How far can oil price plunge ?
What is the weight of fossil fuels on the economy is an important question as fossil fuel is still essential to our economies The price has fallen by more than 30% since the start of the year and yet the worst is yet to come, experts say. The spread of the Corona virus is not unrelated to this. One might think a priori that a low oil price is attractive, especially when you fill up the tank of your car. However, it is more complicated than that and oil remains a key indicator or measure of the current level of the economy. As we know, Saudi Arabia has launched a price war. The strategy is to impose maximum pain quickly on Russia and on the other producing countries to bring them back to the negotiating table, before starting a reduction in production to raise the price of a barrel. One wonders if Covid-19 was the right time in the middle of a storm. We are reliving what we experienced in 2016. It’s a game like “who loses, wins”. Some countries unfortunately are already in bad shape despite their oil production. Another fall would be fatal. This is not without consequence, both on the producing countries and on their customers. The fall in the price of a barrel, although mechanical and intended, has several causes. First, the slowdown in demand, especially from China. The end of a particularly mild winter and sluggish markets in the midst of a health crisis. Many industrial sectors are therefore operating at a slower pace, which is driving down demand for oil. The explanations are also to be sought on the supply side.
Race for low barrel prices
Some producing countries, notably Saudi Arabia, are flooding the markets, preferring to race for low prices. They do this to compete with American shale oil, but also because all of them refuse to slow down their production as long as the others do not, for fear of finding themselves alone in charging prohibitive prices. It is therefore the snake that bites its tail: no one taking the initiative to control production, it remains at its maximum. So, who benefits from the crime? Are we not facing a Pyrrhic victory? For importing countries, low prices are a boon, making it possible to reduce the production costs of businesses and households, boost consumer purchasing power and avoid trade balance deficits in non-producing European countries. Companies can invest or hire, households increase their consumption. These behaviors have positive effects on the overall economy of a country. Logically, the fall in oil therefore improves a country's trade balance. Those who are penalized are ultimately the producing countries. Especially since, for most of them, oil represents a very important part of exports. The wealthiest of them, like Saudi Arabia and the United Arab Emirates, have enough funds to compensate, for the moment. But for others, like Venezuela, the consequences are immediately felt. And these economic difficulties can have direct social and political consequences, as we have seen recently. Nevertheless, we saw now that a price below 30 USD is possible and that it can go even sligthlly lower.
Who benefits from the crime?
Even for importing countries, the fall in oil prices does not only have advantages. First of all, this is hurting exports to producing countries, which are less inclined to spend. But it also threatens to pull prices down, which, in a situation of low inflation, hides the risk of deflation. This is exactly the problem facing the euro area. Inflation is already very low (to put it mildly). It also deprives states of certain tax revenues. Deflation would otherwise be more problematic, since it would lead to a postponement of household purchases, further price cuts, and therefore difficulties for companies which would be forced to lower wages or lay off workers.
Cheap oil doesn't help the environment
Finally, the fall in oil prices is bad news for the environment, since it discourages public authorities, businesses and households from investing in greener energies. In turn, this can harm the economy, by limiting investment and consumption in the renewable sector. Thus, the interest in buying a less fuel-efficient car is no longer as obvious when the price at the pump drops. It’s paradoxical but alas the sad reality. The rebalancing of supply in the short term should mainly come from the reduction in unconventional production, shale oil. Its operation is indeed too expensive to be profitable when prices are very low.
The price war has started again
A war therefore seems to have started and will leave its mark on everyone, including the one who instigated it. Producing countries, in my opinion, have underestimated the impact of the virus on energy consumption. Oil remains expensive in Europe mainly because of the huge taxes collected by the States. The Dollar remains strong against the Euro. The average consumer will therefore not see a significant drop in their fuel tank. The price of energy is therefore a huge influencing factor in the economy. I do not think that the current situation suits the affairs of the European Central Bank. The simplistic effect of believing that the price will increase consumption may be true, theoretically, if other exogenous factors do not disrupt mechanics. Movements that are too fast and too violent are never advisable in economics. Nor should it slow the process of "greenization" which is already far too slow in the face of clear climate change. This extremely mild winter in Europe attests to this.
Traders are upset and lose
The biggest oil traders have announced their fears of the weakest demand for oil since the start of the financial crisis in 2008. The Corona virus outbreak has led the biggest oil traders to slash their projections for growth in the global demand to the weakest levels for a while, with many expecting consumptions to stay steady or even shrink in 2020. Traders foresee problems resulting from the virus. The impact of the virus is likely to become greater than many analysts had expected.
Now is no longer the time to finance fossil fuels
After the EIB’s announcement, it’s no longer time to finance fossil fuels. JPMorgan also announced that it will stop funding coal-fired electricity production unless the producer offsets its emissions by capturing and storing carbon dioxide. JPMorgan will do the same with oil and gas financing projects in the Arctic. American banks, including Goldman Sachs, are turning to the financing of projects combating global warming. They want to focus on sustainable projects. For JPMorgan, the bank that financed the most oil-related projects, it was an obligation, especially since they were tormented by anti-oil activists. The surrounding "climate skepticism" does not help the Directorates and pushes them away from oil. In addition, banks are now integrating climate risks into customer risk analysis. “Green” ratings will increasingly condition the spreads applied to customers. Being virtuous will be rewarded in cost of financing. We can hope that everyone will play their part in helping to decarbonize the world. We have a long way to go, regardless of the price of oil.
Fran?ois Masquelier - SimplyTREASURY