- March 17, 2020
- Posted by: Art Berman
- Category: header-menu
Saudi Arabia has repeated the blunder it made in November 2014 by increasing oil production during an oil-price collapse. In 2014, it led to a depression in the oil industry. This time, it may be the tipping point for a global economic depression.
On Saturday March 7, discussions between Saudi Arabia and Russia ended with no agreement to cut production. On Sunday, Saudi Arabia announced price cuts and its intention to boost production. The largest single-day fall in oil prices occurred the next day (Figure 1).
Things were not looking good for oil prices before then. Prices had peaked in early January with the assassination of Iranian General Soleimani, the announcement of a U.S. – China trade agreement and an OPEC+ production cut. As I wrote in late December, the price rally was doomed because it was based on sentiment and not market fundamentals.
Then the Coronavirus outbreak became public. I wrote in early February that Coronavirus would crush oil prices. It did. The Saudi price cut in March compounded and accelerated the collapse of oil prices and of broader markets.
Why It Happened
Mohammed bin Salman (MBS), the Crown Prince of Saudi Arabia delivered an ultimatum to Vladimir Putin, the president of Russia, to cut oil production on his terms. Mr. Putin doesn’t accept ultimatums so he ignored it. MBS cut prices and announced a production increase.
The events of the past week were an axiomatic response by Saudi Arabia taken from earlier playbooks. Between 1981 and 1985, the Saudis cut their production by 6.8 mmb/d hoping to stop the decline of oil prices in the face of new supply from the North Sea, Siberia and Mexico (Figure 2). King Fahd got tired of cutting without much help from OPEC allies and with no resulting price relief. He fired oil minister Ahmed Yamani, cut prices and increased production.
In 2014, world oil prices were again collapsing. Saudi oil minister Ali al Naimi asked Russia to join OPEC in cutting production. Russia refused. Saudi Arabia cut prices and increased production. See the pattern?
The guiding principle of Saudi oil strategy over the last three decades has been to never again make the mistake it made by cutting production alone in the early 1980s. Analysts and journalists who say that there is a price war or a war on shale should study history instead of inventing mindless memes.
“The coronavirus epidemic will lead to “a global recession of a magnitude that has not been experienced before.”
The prolonged hiatus in economic activity particularly in the United States and China makes a global depression practically unavoidable.
Energy is the economy and most of the world’s energy comes from oil. The present devaluation of oil will spread to other commodities and currency. Although oil-price devaluation was inevitable because of coronavirus, the recent Saudi price cut and production increase have accelerated and compounded its effect on the global economy. It may become a Lehman moment.
GDP will fall as less oil is consumed. That is empirical–GDP and oil consumption have an R2 correlation of 0.96 (Figure 3). What may not be well understood is how much the U.S. and China dominate this relationship.
Figure 3 shows two charts using the same data. The graph on the left has logarithmic scales and the graph on the right has cartesian scales.
The left-hand graph shows the correlation. The right hand graph shows the disproportionate weighting of China and the US on both GDP and oil use. Together, they account for 32% of world GDP and 34% of oil consumption.
China’s oil consumption is probably down 4 mmb/d for the first quarter of 2020. If it returns to normal by Q2 (unlikely), that implies ~1% drop in annual global GDP. Things won’t normalize in China and the U.S. contraction will compound lower consumption well beyond Q1 not to mention lower consumption in the rest of the world. There are lots of reasonable objections to using this correlation deterministically but it offers a high-level perspective about where the economy is probably going. That’s why it is difficult to imagine an outcome other than depression.
There will be a lag between falling prices and demand, and a corresponding decrease in production. Meanwhile, inventories will build and some expect that global storage capacity will be exhausted by summer. Is that reasonable?
Figure 4 shows the accumulation of comparative inventory accompanying the last oil price collapse in 2014. 5 months elapsed from the beginning of price decline until C.I. reached the 5-year average. It was another 18 months before peak storage and minimum price were reached. Despite analyst expectations, neither U.S. nor global storage capacity were filled.
Comparative inventory is just below the 5-year average currently. Assuming a similar rapid fill rate, maximum storage levels would not be reached until July 2021. Today’s WTI settle price of $28.70 is almost as low as the minimum level reached 4 years ago suggesting that price may have much farther to fall before finding a bottom.
It seems unlikely that the virus will be contained before the second half of 2020 at the earliest. That is why I expect an economic depression and oil-prices of $20 or lower before long.
When the normal spread of a disease transforms into an epidemic, it is called a tipping point. It is that moment when a small change tips the balance of a system and brings about a large change.
We are there. I’m not talking about coronavirus. I’m talking about the tipping point of our civilization.
Humans have not evolved emotionally since hunter-gatherer times on the African savanna. We believe that the planet’s space and resources are ours to use however we want regardless of implications for the earth and its other species.
We have developed an economic system that values economic growth above all else. Oil, more than any other factor, has super-charged our economic growth over the last century. When growth began to slow as oil became more expensive, we turned to debt, a call on some future energy surplus. The Financial Collapse of 2008 was a signal that we needed to de-leverage our debt. Instead, we devised clever ways of papering over the debt problem with more debt.
Now, the coronavirus has abruptly stopped the machinery of growth. Contagion–man’s primordial fear–is spreading. Markets are collapsing and there are no solutions in sight. The most social of species is facing isolation.
We have crossed a threshold. It cannot be successfully crossed in fear. The virus will pass and this is not the end of times. Still, things will not return to the way they were before the tipping point was reached. We must finally seek balance with each other and with the planet, and, hopefully learn to live with less.