In early January 2020, Brent oil was trading just over 70 USD per barrel; however despite a turbulent 2019, the New Year would not foreshadow — by any means — the disastrous future.
Rising Geopolitical Tension
The tension across the Middle East and North Africa (MENA), from the Libyan civil war to the Erdogan-Assad standoff in Syria, the continuous escalation between the US and Iran — which reached its peak after Soleimani’s killing — and the unsuccessful long-term intervention of Saudi Arabia in the Yemeni front, alongside the drone strikes in the Aramco facilities by Houthi rebels have outlined a jarring scene of global geopolitical uncertainty. The critical role of those regions in the shaping of the international energy markets, has been pushing extremely volatile oil prices higher. Yet a series of unforeseen factors has entirely restructured the global energy landscape, causing fundamental changes that could never been predicted — and which have never happened before.
The Russian-Saudi Face-Off and the COVID-19 Final Blow
The first signs of the price collapse to come were visible by early to mid-February 2020, when China did not allow to oil tankers to unload their cargo at the terminal of Qingdao, one of the most important points of crude oil import in China. With many regions across the country already in lockdown due to the COVID-19 outbreak, the need for crude oil had been dramatically reduced and the storage facilities were already overloaded.
At the same time, talks between Moscow and Riyadh for supply control and a cut in daily oil production led to a dead end. With Russia walking away from the talks, KSA proceeded to apply a discount of approximately 7 USD per barrel for its clients. They did this in order to put pressure on Kremlin. These developments took place on early March leading to a race to the bottom for oil prices.
Shortly after, the exponential growth of COVID-19 all around the globe became apparent, and the WHO declared the virus a pandemic. This created the perfect storm. The Russian-Saudi standoff has blocked daily production control, triggering overproduction and the COVID-19 outbreak caused global demand to plummet -reportedly the global oil demand went down by 33% in a matter of days- with a devastating impact on international energy markets. Brent oil reached historic lows, trading close to 20 USD per barrel, while things have been even more peculiar when it comes to Western Texas Intermediate, the Texas light sweet crude oil, referred as WTI.
The Negative Contracts Paradox Explained
Last week the negative oil contracts made headlines, as many people were trying to figure out the paradox of the once precious commodity trading in negative prices. Apparently, the negative prices were not referring to the value of WTI oil per se, but rather to the future contracts of the commodity. Future contracts constitute a financial agreement where two parties agree in exchanging money for an underlying asset, in this case oil.
The price of the future contract is specified and a date for this exchange — the expiration date — is determined. The panic triggered by the oil supply vs. demand inconsistency should be attributed to the fact that many contract holders have not managed to sell their contracts as the expiration date was approaching. The WTI oil traded through future contracts is delivered at the pre-agreed (expiration) date in the storage facilities of Cushing, a small city in Oklahoma. Since mid-April the storage capacity in Cushing has been gradually filling up.
The contract holders -often traders seeking to generate profits though speculation and exchange of the contacts, rather than being interested in ultimately possessing the underlying assets- had to either sell the contracts as soon as possible, or cover the delivery process of the oil they owned. With such reduced capacity, making the delivery and storage process really pressing and costly, many contract holders were anxious to get rid of the contracts before the expiration, even if they had to pay for someone to accept them; thus the negative price of the May WTI contracts, an unprecedented situation as future contracts have never been traded at negative value in the past.
The scenario of a repetition of this paradox is not unlikely; as there is planning for the Covid-19 countermeasures to be gradually lifted worldwide, the demand will start slowly rising again while the offer will keep building up. Considering that the travel and transportation sectors are the mostly affected and they will need a long time to get back on track, the storage and delivery issues could still remain, prolonging the volatile sentiment across energy markets.
The Sociopolitical Impact in Oil-Rich Countries
Looking almost a decade back when the Arab Spring was spreading across MENA, it would be worth considering how the oil-rich Gulf monarchies managed to handle the crisis. While the wave of revolutions eventually toppled decade-long regimes across the region, regimes perceived to be all-powerful and unlikely to be ever removed, the impact on the Gulf states has been minimal.
This can be explained by the fact that the huge revenue generated by the oil reserves, allowed to countries like Saudi Arabia to deliver stimulus packages and financially boost their citizens. These measures combined with some virtual reforms were enough to decompress any critical mass of tension. Kuwait, KSA and UAE have all tried to diversify their national economy and gradually decrease the absolute dependence on the energy industry, over the last decades.
However, all these countries are still relying heavily on the oil production. A long-term extension of the current situation could limit the capabilities of the government to efficiently manage a wide in-country movement pushing for further changes, especially if there are similarities with the Arab Spring dynamics. But also, any economic difficulties in the Kingdom of Saudi Arabia could trigger a domino effect across the wider region.
Several poorer states within MENA are receiving financial assistance from the Kingdom, while the Gulf states have been a destination where many foreign workers from other Middle Eastern countries are migrating. Lebanon has already been in deep turmoil for several months and the crisis will only worsen the situation. Morocco and Jordan have been also receiving financial aid and a potential financial crisis due to the collapse of the oil prices among the oil-rich monarchies, could cause significant collateral damage and trigger sociopolitical unrest in a particularly broad area.
Things look even grimmer for developing countries or emerging economies whose financial standing is reliant on the oil prices. Iraq generates a massive 90% of its revenue from oil. The public sector and the social security system of the country is plainly based upon oil. According to the current estimation the situation in May will become greatly challenging. Oil accounts for the 90% of the export revenue for Nigeria and the funds gained from oil export cover a significant amount of the total governmental spending.
While Nigeria has seen an impressive average 7% GDP increase per year from 2000 to 2014, the oil prices downturn took this growth rate down to 2.7% between 2014 and 2016, according to the World Bank. The current crisis could have a much greater impact, as Fitch ratings estimate a 1% recession for 2020 and things could be slightly better in 2021. Such a development in Nigeria could also destabilise further neighboring countries, that are strongly relying on Abuja. Like Chad that has to deal with the remarkable problem of a re-emerging Boko Haram, or Benin, whose national economy would be directly affected by any turbulence in the Nigerian markets.