Oil Prices Crash – Reasons & Impacts for India & Global Economy [Updated]

On April 2020, the OPEC countries and allies have agreed on a historic deal to cut global petroleum output by about 10%, ending the devastating price war between Saudi Arabia and Russia. Recently, the world’s major producers agreed to extend the first phase of the original deal for another month and further reduce the supply by 9.6 million barrels per day in July. While this has helped to boost the oil prices since their collapse in April, the success of the recent deal depends on compliance by poorer countries that refused to fulfil the original deal.

This topic of “Oil Prices Crash – Reasons & Impacts for India & Global Economy [Updated]” is important from the perspective of the UPSC IAS Examination, which falls under General Studies Portion.

Why are oil prices crashing?

• The sudden decline in the oil price had begun with the scare brought on by the spread of the coronavirus outbreak, which is expected to have a major adverse impact on the global economy.
• Amid the on-going pandemic, it is estimated that oil demand will fall in 2020, with demand growth estimated to be 48 million barrels per day from the earlier forecast of 1.1 million barrel per day.
• This along with a reduction in factory output and transportation demand has also brought down the overall demand for oil.
• The Organisation of Petroleum Exporting Countries (OPEC) had held an emergency meeting on February to recalibrate its production cuts for the rest of the year.
• It had planned to cut the production by another 1.5 million barrels per day until the end of this year, which would have reduced the global supplies by 3.6%.
• However, Russia refused, as it did not want America’s shale companies to benefit from the policy of supply restraint stated within OPEC+ deal.
• In response, Saudi Arabia had launched a price war, leading to the collapse of OPEC+.
• A price war is an economic tactic used by large players to regain market share.
• It aims to cut prices, which forces firms’ competitors to do the same. Eventually, the smaller and marginal firms will struggle to survive such low prices, forcing them to quit the market.
• This vacated market share will be regained by large firms.
• This along with the coronavirus pandemic has led to a decrease in the crude oil price.

What is OPEC+?

• In December 2016, the joint efforts of Saudi Arabia and Russia led to the signing of Vienna Agreement between the OPEC countries and 11 non-OPEC countries (currently 10 as Equatorial Guinea joined OPEC in 2017).
• This agreement aimed to decrease oil production to prevent the fall of oil prices and ensure their stability.
• The initial six-month deal was extended several times afterwards, leading to the formation of a permanent forum-like structure called OPEC+ with its own charter signed in July 2019.
• This new grouping allowed the participants to coordinate and adjust their production policies.
• This format proved to be effective and had achieved relatively high and stable policies until now.
• In December 2019, the deal was extended until April 2020.
• On March 6, Saudi Arabia tried to push for additional oil production cuts to compensate for the slump in demand due to coronavirus outbreak.
• Russia not only rejected this move but also announced that it will no longer abide by the previous cuts.
• This resulted at the end of OPEC+ policies of production cuts.
• This situation of reduced oil prices would hit US shale producers, who continue to benefit from OPEC production cuts by expanding their market share.
• A price collapse may put some of these producers out of business due to high production cost.

Were there previous instances of price war?

• Saudi Arabia had waged four price wars, including the current one, over the last 35 years.
• Each war lasted at least a year and prices plunged at least 50%.
• Price War I: In June 1985, Saudi Arabia had warned that it would no longer carry the burden of production cuts alone. In November, the country moved to flood the market. The price plunge lasted until December 1986.
• Price War II: It initiated in November 1997 when Saudi Arabia boosted its production to counter Venezuela, which was rapidly seizing the market share in the US market. Saudi Arabia did not anticipate that demand would collapse amid the emerging market crisis and warm winter. The oil price dropped from $20 per barrel to less than $10 per barrel. This situation lasted until April 1999.
• Price War III: It started in November 2014, in response non-OPEC countries freeloading on the cartel’s production cuts and the impact of the US shale revolution. Saudi Arabia had adopted a policy of pump-at-will. Oil price collapsed just like in the previous cases and did not come up until September 2016 when Saudi Arabia and Russia formed OPEC+ to ensure cooperation in the price cuts.
• This time, the battle is more brutal at the initial stage, with price crashing more than 35% within a few days. In the past wars, prices fell slowly, over a period of months. Riyadh’s move may just shorten the fight by inflicting more pain so that everyone will come for peace negotiations sooner.

How does the Coronavirus outbreak worsen the situation?

• The pandemic has reduced the energy demand worldwide, especially in China, which is the largest importer of crude oil, accounting for nearly 10 million barrels per day.
• Factories have stopped working and thousands of flights were cancelled across the world as the coronavirus outbreak began in Wuhan.
• It is estimated that the oil price may even go below zero (negative) as oil supply surpasses global storage capacity.
• Negative oil prices may lead to bankruptcies in the oil and gas sector and if it lasts long enough, countries may even face economic collapse.
• The global oil demand is only around 100 million barrels per day. However, the economic impact due to COVID-19 could reduce it by up to 20%.
• This would create 20 million barrels per day surplus of oil in the market that would rapidly exceed the storage capacity, forcing the oil producers to pay customers to buy the commodity.

How does this situation affect other countries?

• During this situation, it is difficult to see any winners.
• The major oil-producing companies will lose money regardless of the market share they may gain during this crisis.
• Russia claims to be the most insulated when it comes to the decline in oil prices as its annual budget is based on an average price of roughly $40 per barrel.
• The US sanctions have made it more efficient in dealing with such situations.
• The Middle East countries produce oil at the cheapest rate. However, due to high government spending and generous subsidies for citizens, they need a price in the range of $70 per barrel or higher to balance their budgets.
• These countries, along with Russia have massive foreign reserves to help weather the storm.
• Poor OPEC countries like Iraq, Libya, Nigeria and Venezuela are highly dependent on oil for their economic growth. They have already suffered due to conflicts, uprising and sanctions. These countries will be the worst hit during this situation and their economies may collapse if it continues.
• The American shale industry will also suffer in the price war.

Why did the price of the US oil turn negative in April?*

• The US oil price had turned negative in April 2020 for the first time in history.
• That means that oil producers paid buyers to take commodities off their hands over the fear of running out of storage capacity by May.
• Oil sales are based on contracts called crude oil futures.
• These are the contracts wherein buyers and sellers of oil agree to deliver a specific quantity of crude oil on a given date in the future at a specific price.
• These contracts can be closed either by physically taking delivery of the oil or by settling the contract by selling it to another buyer in exchange for money.
• Each region has a different benchmark for indicating the price of the traded crude oil.
• West Texas Intermediate (WTI), one of the benchmarks, indicates the price of crude oil produced from the US oil fields.
• The WTI May-dated future contracts were to expire 21 April, which requires buyers of WTI futures contracts to take the delivery of the contracted volume or sell at whatever price possible to avoid taking future physical delivery of the crude.
• The WTI prices turned negative as sellers offered money to buyers to purchase crude oil in order to dump May contracts.
• The causes of this situation are as follows:

1. Coronavirus-led lockdown and reduced demand for oil
2. Scarcity of storage capacity in the region
3. Too many sellers and a very few buyers
4. Sellers keen on closing the contracts at any cost
5. US government’s refusal to regulate oil production and impose mandatory cuts, despite calls to do so in recent G20 meeting that led to historic cuts of 9.7 million barrels per day by OPEC+ countries

How is fall in the oil prices beneficial for India?

• India imports more than 80% of its crude oil requirements.
• Thus, the fall in crude oil price will reduce India’s import bill and the country’s current account deficit.
• Every dollar per barrel drop in crude oil prices reduces India’s import bill by 10,700 crore annually.
• The decrease in crude oil prices will arrest the inflations within the economy. This is because, as oil is a major input in the economy, it is used in critical activities and if input costs increase, so should the cost of finished products. Thus, if the crude oil price decreases, so do the inflation.
• With the easing of the inflationary pressure, the Reserve Bank of India will have the opportunity to reduce the lending rate, more so with the government bond rates at an 11-year low.
• RBI’s monetary policy committee (MPC) had put a halt to its lending rate cuts in December last year due to the mounting inflationary pressures.
• A repo cut will ensure lending at a lesser cost, which will result in a spurt in economic activities.
• This situation may also aid in increasing revenue and improving the fiscal balance of the economy.
• Due to the recent economic slowdown, it led to a precarious fiscal situation because of the reduction in revenue for the government.
• This situation can increase government revenue, which can be used to spend or meet the financial commitments of the government and enhance the growth of the economy.
• Additionally, having surplus cash may ensure an increase in the consumption within the economy and thus boosting economic growth.
• It may also provide a breathing space of the ailing sectors like telecom.
• Currently, coronavirus pandemic has led to huge losses for the hospitality sector, aviation sector
• However, if oil prices remain low over an extended period, it will aid the Indian economy to offset the impact of coronavirus.

How is this situation a threat to the Indian economy?

• Usually, a fall in the crude oil prices is good for the Indian economy as it favours the trade balance and helps in economic growth.
• However, the current decline is during the time of global slowdown that is destroying equity markets.
• It should be noted that the current account deficit depends on rupee’s value, which is currently at very low against the dollar. This is because crude oil is bought and sold internationally in dollars. However, in the long run, due to the decrease in the oil price, there will be an increase in demand for the dollar as a result of an increase in oil imports.
• Also, the fall in the oil prices come at a time when the global economy is already reeling under the impact of coronavirus, which has decreased the demand across sectors and economies. Thus, the situation is not favourable for India to use this opportunity.

How did the Indian government make use of the global decline in oil price?*

• According to the Petroleum Ministry, India has saved Rs.5,000 crore in foreign exchange after it capitalised on the global low oil prices to fill up its underground strategic oil storage to its full capacity.
• 33 million tonnes of emergency storage (enough to meet India’s oil needs for 9.5 days) in Mangalore and Padur in Karnataka and Visakhapatnam in Andhra Pradesh was filled up by the government.
• The state-owned oil firms were also asked to import oil in April when global rates fell to a two-decade low.
• India’s refineries maintain 65 days of crude oil storage and when added to the storage of strategic reserve, the Indian crude oil storage tally is about 87 days, which is close to the storage of 90 days mandated by the International Energy Agency.

What can be the way forward?

• During the last major oil price crash in 2014-16, the Centre and states used the opportunity to hike excise duty and value-added tax on petrol and diesel and very few consumers benefited from it.
• Similarly, the government may repeat the policy and use the excise duty to ensure the promotion of infrastructure projects and improve the productivity of the economy.
• This situation may not last for a long time. Therefore, India must increase its strategic reserve capacity as soon as possible.
• It is estimated that the government would save between $500 to 600 million if 50% of the existing reserve capacity is filled with Gulf oil.
• If full capacity is contracted and filled, the country would be in a position to meet 5 days of its oil needs through the strategic reserve.
• The government has decided to take advantage of this situation by buying from Saudi Arabia and UAE to top up its strategic oil reserves.
• Apart from these measures, India needs to reduce its dependence on oil by increasing the use of renewable energy resources and electric vehicles so that the economy is not vulnerable to unstable international politics.

Conclusion:

The reduction in oil prices due to the price war may be a temporary situation as Saudi Arabia and Russia cannot sustain low oil prices for long. Considering this situation, India must make use of it diligently. However, it may not gain the full potential as it has occurred during the time of a pandemic that has halted the economic growth of many countries. Thus, the government must take necessary steps to ensure that its reserves are filled, as this opportunity may not occur again in the near future.

Updates*

How did the 2020 price war end?

• OPEC+ countries have agreed to 9.7 million barrels per day cut from 1^st May 2020 for an initial period of two months (May and June), making it the single largest output cut in history.
• This amount would further be reduced to 7.7 million barrels per day for the remaining 6 months of the year and to 5.8 million barrels per day for 16 months after that.
• This deal marks the end of the price war that toppled energy markets and aggravated the effect of the COVID-19-led economic crisis.
• This historic production cut represents around 10% of global oil production. Yet, it is predicted to be insufficient to offset the 26 million barrels per day decline in the demand due to the ongoing pandemic.

What are the outcomes of the recent OPEC+ meeting?

• At the beginning of June 2020, OPEC+ countries have committed to extending May and June oil supply cuts for another month.
• The OPEC+ agreed to reduce supply by 9.6 million barrels per day in July. This is much lesser than the April agreement of supply cut by 9.7 million barrels per day for May and June.
• The reduction comes in response to Mexico, the only member of OPEC+ alliance that refused to extend the original commitment through July.
• Furthermore, the group’s monitoring committee would now meet every month to assess the balance between supply and demand amid the uncertain economic recovery from the global pandemic.
• This new deal would fortify the oil market’s recovery and ease the financial burden felt by the oil-dependent countries, US’ shale exporters and others.
• After this agreement, experts believe that the supply deficit is almost certain, with an estimation of global production deficit of about 1.5 million barrel per day in June, 4.6 million barrels per day by July and 4.2 million in August and then dropping slightly before peaking at 5.2 million barrels per day in January 2021.
• Experts also pointed out the poor compliance by countries like Iraq, Nigeria and Angola with May-June cuts. They emphasised that the recent agreement depends on these countries reducing their output from July to September to make up for the overproduction.

Practice question for mains:

Critically examine the reasons behind the recent price war between Russia and Saudi Arabia. How did it affect the Indian economy? (250 words)