The COVID-19 impact on the oil industry

oil industry

Pulling off all onerous feats since its inception, the Covid-19 crisis just added another victim to its list - oil. In an unprecedented event, oil for the first time in history breached the $0 mark, forcing the mankind to readjust the axes – another impossibility coming true! The WTI (West Texas Intermediate) futures contract of May expiry fell by over 300% to trade at below ‘minus US$39 per barrel’ on the NYMEX on Monday, April 20th. The Indian counterpart, MCX, accordingly had to settle the price at just INR 1 per barrel showing that it was unprepared for such an unusual volatility in the international markets.

A condition called ‘Super Contango’ has sent the oil markets into frenzy. A Contango market implies that oil traders believe crude prices will rally in the future. Thus, spot prices are being offered at super discounts to futures prices. In fact, the spread between the front and the second month is the widest now ever in its history (with WTI June and July expiry futures trading at c. US$20/barrel and c. US$26/barrel respectively).

The primary reason behind this freefall is the lack of fuel demand across the world followed by a glut in global oil markets leading to an acute dearth of available storage capacities. Thus, increasing the number of market participants who are unwilling to risk doing physical deliveries anymore. Instead of obeying the future contracts at expiry, the idea of relentlessly selling the front month’s contract at the open market and rolling it over to the next month, appears more feasible.

Unlike Brent crude that is produced near the North Sea and settled in cash at expiry, West Texas Intermediate is produced in landlocked areas and has to be delivered physically, thus, making costs a burden for the latter from a transportation standpoint. This leads to greater uncertainties revolving around WTI prices than Brent crude as can be seen from the fact that Brent crude prices declined less dramatically on Monday and were still trading at levels close to US$25/barrel.

What this means for the global economies? With no recovery in sight in the foreseeable future, the key issue of oil storage is likely to stay. If the oil stays at pennies, the US shale companies would have to pay to dispose the excess stock off! As a result, they may have to further reduce the production by shutting down their rigs and oil wells to avoid plunging into deeper financial troubles. Note that the global demand has shrunk by c. 20MMbpd and oil production has already been slashed by 10% after OPEC and Russia reached a truce earlier this month.

Keeping aside the theoretical aspects, there are additional operational and strategic challenges in cutting production. Operationally, there is only up to an extent that a company can do so. To cut production further, they may have to seal their oil wells and thus, risk losing the asset permanently. Strategically, this would mean recurring capital and abandonment expenditures when the market revives and losing its market share to its competitors in the longer run. If major oil producing nations like the OPEC countries choose to do this, their currency might devalue significantly.
A silver lining to this fiasco, from a consumer’s standpoint, is that reduced oil prices help in slowing inflation.

However, cheaper fuel may appeal to consumers in the shorter run, but this would also mean lower or no dividend payments by the financially burdened oil companies to the pension funds in the longer run; indirectly affecting millions who are reliant solely on their pension incomes.

What does this mean for India? The government earns a large chunk of its income from excise duties with roughly 90% of it coming from oil imports. It is interesting to note that the prices for retailers have not been reduced since the government is using the buffer to fund its expenses. However, once the lockdown ends, the government can face increased pressure to reduce the fuel prices for consumers.

Indian oil companies, especially the E&P space (upstream) like ONGC and Oil India, may face tough times ahead because of increased pressure to sell their products at lower prices ahead. The refiners and distributors (downstream) like HPCL, Reliance and IOCL are likely to see improved margins in the coming quarters, once the demand picks up again. As for the storage, if the Indian companies can manage their stockpile well, this is a good time to buy and reserve oil for future use.

As per the Reserve Bank of India, India’s current account deficit (CAD) stands at 0.2% of GDP, as of December quarter in FY20 as compared to 2.7% in same quarter in FY19. Since, India imports more than 80% of its oil consumption, lower oil prices are likely to reduce the CAD for the economy. The current savings in CAD can, then, be used to continue financing the urgent relief measures against the domestic Covid-19 outbreak.

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