What happens when something inelastic, breaks?

While the supply of oil is high, and prices are the lowest in 20 years; fear and a pandemic has made demand almost non-existent

Executive Summary:

  • Oil prices hit the lowest they’ve been in two decades; this is due to a price war between Russia and Saudi Arabia (who increased oil production in the past few months after a disagreement with Russia). Saudi Arabia requires a price of $80 a barrel for viability, therefore they can survive these low prices for a few months before serious problems occur.
  • US and foreign oil companies can sustain losses for the current ‘First Wave’ of the pandemic, but will be hard pressed, without bailouts, and adaptation if there is a ‘Second Wave’ which is probable without an FDA approved vaccine.
  • Oil is a resource that will continue to play an important role in many industries, but the current health crisis provides an opportunity for Governments and people to push for pro-sustainable resource legislation and the infamous ‘Carbon Tax.’ Without legislation renewable resources will thrive but will not overtake oil for the foreseeable future even though in 2018 and 2019 renewable resources were cheaper than oil.
  • Although huge cuts to production are happening this will not affect the price of oil in the short run. Currently there is still a huge oversupply that will continue getting larger until the end of mass lockdowns. Oil reserves are already close to being full and even with an expected increase in demand in the summer, there is no guarantee it will return to ‘normal’ levels. In the long run (2021) with huge reduction in overall supply / production we could see the higher price points at an expedited rate due to these cuts. If companies had not slowed their production in the last few days, prices would have had a very slim chance to return to a price above $40 a barrel until 2022 or later.

Background and Analysis:

            People waited for hours, in lines up to 50 cars in order to get gas during the 1970s oil crisis. There was mass hysteria, hoarding, and fear because a good so fundamental to everyday American life was in shortage and more expensive than anyone could imagine. Today’s crisis has its similarities and differences. There is an abundance of gas, and prices are at an incredible low; there is also mass hysteria, fear, and hoarding of toilet paper. Go figure.

Oil is traditionally an inelastic good. An economist 10 years ago may have argued that it’s only “relatively” inelastic as shortages of fossil fuels coinciding with environmental consciousness sparked a push towards renewables. Today oil is far from elastic, but is it necessary? Yes. Is it going to play a major role in the world economy for the next 10-20 years? Yes.

Organizations like OPEC, Russia, and even the Shale companies in the United States have seen a much different landscape in the past eight years. There is a large amount of oil in the ground and with better technology, better resources, and a push for energy in an array of industries, supply has been at an all time high. Due to COVID-19, demand has plummeted drastically.  If demand fails to rebound or oil companies fail to adapt, the economic impacts will be far reaching. While cheap energy prices seem great, and in the past have provided impetus for huge economic progress, oil can be ‘too’ cheap. Over the past decade the US has become the worlds largest producer of oil in efforts to become self-sustaining. There are over 500k workers in the oil industry, and with US and foreign oil already ramping down due to cheap prices, and the looming fear of low demand in the coming months there’s bound to be layoffs. Low fuel costs to create a stimulus for production and manufacturing is difficult to justify: 1. If due to the pandemic these industries are fundamentally changed and don’t consume as much fossil fuels, 2. If consumer consumption does not return to normal levels due to continued fear and a new ‘normal’ of social distancing.

            High supply is one part of a much more complex problem. According to Michael Liebreich at Bloomberg New Energy Finance, to meet a fiscal ‘break even’ Saudi Arabia needs to sell for $80 per barrel, while Russia needs half of that. The United States normally requires $48 to $54 to break even, but these prices have varied with the surge of Shale, an extremely cheap but volatile alternative. These numbers paint a frightening scenario for at least one of the world’s top manufacturers. Saudi Arabia’s ‘Vision 2030’ plan reduced their reliance on oil as a driver of GDP; thus, energy reform is not unexpected, but the reckoning may come sooner than desired. Carbon Tracker estimated oil demand would peak in 2023. Cleaner, energy efficient technologies have been cheaper sources of electricity than oil for the past two years and are now the same cost.  With current decreased demand, 2019 may have been the peak.

            This harsh reality shouldn’t come as a shock to a country that has invested almost half a trillion dollars into this clean energy in the past decade. But this doesn’t mean an end to oil, but instead a change in its role in society. Too many industries rely heavily on oil for this pandemic to create sweeping change. America’s reliance on fossil fuels can’t be upheaved in a few months or even in a few years. This knowledge is overshadowed by the fact when life returns to a new ‘normal’, oil prices will still be relatively inexpensive. Oil will have a resurgence, at least in the meantime.

Governments have an excellent opportunity to use this period as fuel to push a ‘Carbon Tax’ and make sweeping legislative changes towards renewable resources. If they do renewable energy may be able to ride this wave to the front. If this isn’t done, oil will continue to be our main energy drive for the next five to ten years. Unless we keep a close watch over where stimulus money is going, and how our Government and society is viewing the industry change will not happen. If a vaccine isn’t created before a potential “Second Wave” happens, some industries including oil cannot survive without expensive bailouts or adaptation. This would cause renewable energy to thrive, but the ramifications to the economy could be substantial.

The future is always uncertain, but in todays climate there are two very real possibilities. There is a mild or no second wave of cases of the virus, and there is a huge demand increase during the summer (under the assumption quarantine is lifted at that point). Without a second wave of infections, demand would grow back to similar levels under this new ‘normal’ and could exceed $40 in the next year. If there is a second wave and social distancing is reinstated, the oil industry will be poised like the banks in 2008. Massive bailouts would be needed but this would be poorly received by the general public which is continuously pushing for greener alternatives. This poses a huge risk not only to the oil industry, but also to the hundreds of thousand employees it has. With layoffs there would be a huge influx in loan defaults from the consumer level, but also defaults on commercial loans to parent companies. The best we can hope for is a vaccine, or oil companies drastically changing the way they do business to find alternative energy uses in order to break even.

Big Oil truly is too big to fail, but the industry, and prices may seem like they have in the short run. Massive production cuts agreed upon in mid-April are important for the industry, but not for the reason you may think. Oil is still massively over-supplied and will continue to be for some time. If the industry didn’t decrease production now, they wouldn’t see the price of barrels go up until 2022 or later. With the expectation of the economy going back to somewhat ‘normal’ summer prices will continue to be low. Due to the production reduction the industry may see the price of a barrel reach above $40 by 2021 rather than a 2022 or later, because they decreased production. This play will decrease the amount of hurt they see in the long run, but also poses problems as many drilling and shale production have never ‘turned off’ and are not sure if they will be as productive when ‘turned back on.’ The future remains uncertain, but Big Oil has made a power play to remain relevant.

Resources:
https://www.wsj.com/articles/covid-19-makes-oil-markets-sweat-11583856025?ns=prod/accounts-wsj
https://www.weforum.org/agenda/2020/04/oil-prices-could-remain-depressed-for-at-least-a-year-heres-why/
https://www.cnn.com/2020/04/03/business/oil-prices-opec-meeting/index.html
https://www.forbes.com/sites/tomkonrad/2012/01/26/the-end-of-elastic-oil/#5108501a36d6
https://www.theguardian.com/environment/2020/apr/01/the-fossil-fuel-industry-is-broken-will-a-cleaner-climate-be-the-result
https://about.bnef.com/blog/covid-19-the-low-carbon-crisis/

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