Big Oil again peers into the abyss

A price war, a pandemic and a green energy transition have combined to spark the gravest crisis the oil industry has ever known.

Source: Flickr

This year, the oil and gas markets have been convulsed by unprecedented chaos. Oil prices have fallen across the board as Covid-19 wiped out demand around the world. Producer nations such as Iraq and Nigeria face crushing burdens on their public finances. And the future of the oil industry has never seemed more uncertain, with giants such as Exxon Mobil, Chevron and BP reeling from precipitous drops in their stock prices.

How did we get here? Arguably, it should not come as any surprise – after all, a global pandemic has been ravaging the world’s economies and shutting down air and road travel everywhere. With the transportation industry occupying such a large share of our petroleum usage – 95 per cent in the United States – it is no wonder that oil demand would free fall as a result.

Yet, the pandemic is only half the story. Two simultaneous factors have conspired with it to produce the situation we see today. The first is short-term: the brief and ill-timed oil price war that Saudi Arabia launched against Russia in March. The second is more long-term and is perhaps the most important of all: the fight against the incessant march of climate change. These two narratives help us understand what has been a truly strange year for oil.

‘A Good Sweating’: The Ace Up Saudi Arabia’s Sleeve

Saudi Arabia and Russia are the two largest oil exporters in the world. The oil spat between them that sank prices in March is a reflection of the two often contradictory goals pursued by any oil-exporting nation: high oil prices, and high volume of output. Increasing output decreases prices, forcing exporters to strike a balance that would maximise their profits.

However, cutting production runs the risk of ceding one’s share of the market to competitors – a classic Nash equilibrium where no player can gain by altering production alone. As such, to maintain both prices and market share, the world’s producers must collude to lower their output together.

This is the basis of the Organisation of Petroleum Exporting Countries (OPEC), a cartel formed in 1960 to coordinate the oil policies of member states. Accounting for a major portion of the world’s oil production and reserves, OPEC would be able to control prices by collectively turning the oil tap. At its centre is Saudi Arabia. As the oil exporter with the greatest spare production capacity, the Saudis have historically wielded the most flexible “tap” and thus the greatest influence over world markets.

However, OPEC is not omnipotent, as the Saudis found to their chagrin in the early 1980s. This was a time of historically high prices, owing to the twin oil shocks of 1973 and 1979. In October 1973, Arab members of OPEC imposed an oil embargo on nations seen as supporting Israel in the Yom Kippur War, including Japan, the United States and the United Kingdom. By January 1974, the price of oil had surged from US$24.49 to $56.21 per barrel (accounting for inflation). Then in 1979, the revolution in Tehran removed Iranian oil from world markets, triggering a second shock that sent prices soaring to $126.36 per barrel by April 1980.

Source: macrotrends.net

Hence by the early 1980s, the Saudis were awash with money – wealthier and more powerful than ever before. However, by the mid-1980s, non-OPEC producers were starting to erode OPEC’s traditional market dominance with new oil developments in Alaska, Siberia, the North Sea and the Gulf of Mexico. With this increase in oil supply came lower prices. Focused on keeping prices high, Saudi Arabia cut production whilst other OPEC producers and new petroleum powers maintained output. This, however, was a significant mistake leading to Saudi Arabia losing considerable market share and suffering a 90 per cent drop in oil revenue. Meanwhile, oil prices continued to plummet, sinking to $65.20 by July 1985.

So in late 1985, Saudi Arabia opened the floodgates, opting to defend market share rather than high prices. Taking advantage of their extremely low production costs, they reasserted their dominance by boosting output and cutting prices to an extent that would render production unprofitable for other exporters. From August 1985 to August 1986, Saudi output rose from 2.3 million to 6.2 million barrels per day (bpd). The oil price plunged from $72.43 in October 1985 to $31.44 in February 1986.

Source: macrotrends.net

The US petroleum industry was devastated, with production cuts in oil states Oklahoma and Texas of at least 7 per cent, and the loss of 100,000 jobs in oil and gas from January to June 1986. As Asjylyn Loder explains, “the U.S. industry collapsed, triggering almost a quarter-century of production declines, and the Saudis regained their leading role in the world’s oil market.” The pandemonium of 1986 spurred the Economist to declare: “Big Oil peers into the abyss.”

Thirty-five years later, and the Saudis have not forgotten their lesson. As China locked down in January/February 2020, OPEC scrambled to react to crashing demand from the world’s largest oil importer, this time enlisting Russia. It was a partnership crafted in the aftermath of the 2014 oil price crash, which brought together OPEC and 11 non-OPEC producers to agree an emergency output cut in December 2016.

However on March 6, 2020, that fragile alliance fell apart. Ongoing talks in Vienna had culminated in a final OPEC proposal to cut production, which Russia now rejected. Unlike in the 1980s, the Saudis wasted no time in their response. They revved up output from around 9.7 million bpd to a record of 12.0 million by April 1, sending oil spiralling from $41.28 to $22.76 per barrel by April 9. On this day, a deal was finally struck – yet there was no immediate respite. Prices continued to dive through mid-April, culminating in the bizarre phenomenon of Texas oil selling at -$37.63 on April 20; traders were paying others to take their oil.

Source: Statista

Saudi Arabia had revived its old strategy of flooding the market to regain a dominant position, wreaking temporary havoc in the process. Yet this technique was first pioneered by none other than oil tycoon John D. Rockefeller, whose flooding tactics secured his Standard Oil corporation 90 per cent of U.S. petroleum refining in the 1870s. In economics, this is sometimes referred to as “predatory pricing”. Rockefeller himself preferred the term “a good sweating”.

The Stranded Ones

If price wars consist of wild, unpredictable swings, the effects of climate change are slow and menacing – yet no less unpredictable. Increasing awareness of the catastrophic consequences of climate change has spurred action by a number of countries to reduce greenhouse gas emissions. Simultaneously, fossil fuel divestment action has gained steam this year.

In August, Harvard University’s Board of Overseers – which exercises influence over its $40.9 billion endowment – welcomed three divestment advocates into its eight-person membership. This follows moves by Oxford University, which in April passed a resolution requiring its fund to shed all investment in fossil fuel companies, and the University of California, which in May fully divested its $126 billion portfolio. According to UC officials, “the reason we sold some $150 million in fossil fuel assets from our endowment was the reason we sell other assets: They posed a long-term risk to generating strong returns for UC’s diversified portfolios.”

Indeed, the outlook is gloomy. David Sheppard of the Financial Times notes that “investors had already turned their back on the [fossil fuel] sector even before the pandemic struck … motivated by fears that demand growth is weakening and the rise of ethical, social and governance-led investing has damped appetites for shares in big polluters.”

The pandemic has amplified this trend. The Boston Consulting Group predicted that under the IMF’s worst-case scenario of a 6 per cent contraction of global GDP in 2020, fossil fuel demand will “definitely not recover [to 2019 levels] this decade.” In the case that “the [green] energy transition accelerates, [recovery] may never occur.” This scenario, which envisions a new outbreak in 2021, is far from unthinkable.

The intertwined emergencies of climate and public health have also driven various governments to link “green” initiatives to their economic crisis-fighting measures. For example, the €750 billion recovery fund clinched by the European Union in late July “earmarks 30 per cent of the entire package for climate protection and says all spending must contribute to EU emissions-cutting goals.” Emblematic of this resolve is the French government’s €7 billion bailout package to Air France, which mandated it to become – in the words of Finance Minister Bruno Le Maire – “the most environmentally friendly airline on the planet.”

Expectations of gradual energy transition have compounded with the pandemic to produce sombre estimates of long-term oil prices going forward. As a result, previously extractable oil reserves may be abandoned as fields become unprofitable to drill, leaving them trapped in the ground as “stranded assets”. Indeed, by July 2020, seven oil giants including BP and Royal Dutch Shell had wiped $87 billion off the value of their reserves since October 2019. Government climate policy was clearly a key driver, with $25 billion of those revisions occurring in 2019 – before the pandemic.

All of this constitutes what is perhaps the gravest crisis in the history of the petroleum industry – and while it may be tempting to celebrate the end of “Big Oil”, it must be remembered what some of the consequences may be. An Oxford policy paper highlights the dilemma faced by fossil fuel-rich developing countries: having to choose between extracting fossil fuels and contributing to climate change, or leaving those resources in the ground and missing out on an opportunity to alleviate poverty.

For some countries the stakes are enormous; according to the World Bank, in 2018 oil profits accounted for 50.0 per cent of the GDP of the Republic of the Congo, with a 45.4 per cent slice for Iraq, 42.4 per cent for Libya and 25.6 per cent for Angola. Falling oil demand worldwide may leave these countries with no choice, facing the prospect of economic disaster as “stranded nations”. As Nicholas Mulder and Adam Tooze argue, “deep decarbonisation will become a formula for social crises affecting hundreds of millions of people. If their states are not already fragile, they are doomed to become so.” Perhaps it is ordinary people that will be the “stranded” ones.

Source: World Bank

Yet this need not be so. By diversifying their economies away from oil, petro-states may be able to avoid the squeeze ushered in by the energy transition. As the policy paper argues, “good governance of extractives and the fight to alleviate poverty need not conflict with global efforts to prevent climate change.”

The unprecedented situation we face today is not only a product of the coronavirus pandemic, but also of structural factors that were in place long before it. One – Saudi Arabia’s “good sweating” strategy – finds its roots in the past. The other is a climate emergency that draws us closer to a menacing future. How the world will respond is impossible to predict, but what’s certain is that the oil industry will never be the same again.