April 7, 2020 | Insight

Energy Markets After Covid-19

April 7, 2020 Insight

Energy Markets After Covid-19

The global oil market entered the COVID-19 crisis with extreme supply excess, created by record U.S. and Russian production alongside an intentional production increase by Saudi Arabia. This week, on April 9, representatives of major oil producing states will convene at an OPEC meeting to discuss ways to bring the oil market into balance. And on April 10, the G-20 will convene an exceptional meeting with the same aim. However, the resulting efforts will likely have only a short-term effect on the oil market. Production cuts cannot offset the decline in demand for oil amidst the COVID-19 lockdown.

Analysts now are trying to adjust to the new normal. Many now believe that low prices and low oil demand are here to stay. But the history of oil prices demonstrates that current market trends set the stage for the emergence of the opposite market trend. As the old adage goes, “Nothing cures low oil prices like low oil prices.”

To be sure, the COVID-19 pandemic has created an exceptional situation. Economic activity cannot respond in a regular fashion to the low price signal. But the pandemic will pass, and demand will resume. When it does, prices will rise, especially in light of supply challenges created by the anticipated shutdown in oil production. Oil production shutdowns and a lack of new investment will mean tighter supply after the pandemic. The Trump administration and other governments will therefore need to craft new energy policies that focus on meeting post-pandemic energy needs. In other words, they will need to look past current market trends.

For now, producer cuts can slow the pace of the oil price drop and the speed at which oil storage capacity is filled (this is expected worldwide by late April or May). But with the loss of demand and the filling of storage, producers are gradually shutting down production. This raises additional concerns about the preservation of production facilities and supply lines that will be needed after the COVID-19 lockdown has been lifted. Lack of investment in future output can also hurt production. The overall damage will depend on the length of time that the industry is shut down, which in turn hinges on the timing of medical breakthroughs or policy changes that herald the return of economic activity.

Oil production cannot shut down or re-ignite with the flip of a switch. Both steps require influxes of capital. Both processes can cause damage to existing fields and infrastructure. This, in turn, can lead to long lags before producers can return to pre-closure output.

The lack of investment is particularly challenging. When prices are this low, few investments in new production will be made. This will limit the ability to meet future demand. Additionally, sustained low oil prices may cause instability in key oil producing countries, such as Iraq, Libya, and Algeria, affecting their ability to renew oil production levels. Widespread COVID-19 infections may also affect some producers, such as Iran.

The initial uptick in demand and price will likely be gradual. Initially, as the world emerges from lockdown, stores of oil will be used, keeping prices low. And low prices resulting from the pandemic actually will help in the economic recovery. But when demand ultimately returns, oil prices could skyrocket.

For now, however, low oil prices are actually a mixed bag for the United States, the world’s largest oil producer. The Trump administration appears to be seeking ways to boost oil price and increase U.S. production. But high prices will come soon enough. Those prices will likely be the result of damage to production caused by the current process of field shutdowns.

Some hold the view that the destruction of oil demand during the pandemic portends a world without oil and the dawn of the age of renewables. This is highly unlikely. The pandemic has especially hobbled transportation, which is oil’s main demand sector. When work is renewed, the demand for energy will return. Renewables currently are simply not technologically ready to meet the majority of the world’s energy needs.

Post COVID-19 behavior will surely affect oil demand trends. To be sure, some companies and sectors may allow employees to continue working from home after the pandemic passes. Others, though, will fear the use of public transportation after the pandemic, and instead drive more miles in private cars.

In parallel to the drop in demand for oil, the U.S. liquefied natural gas (LNG) export industry is also getting hammered in the current economic environment, with demand down in key markets, especially Asia. Potential cutbacks in this industry could have even more significant geopolitical implications than will disruptions in the oil patch. The U.S. domestic market currently is enjoying exceptionally low natural gas prices, but this can change if American oil production downsizes, since much of U.S. gas is associated with oil production. It is worth remembering that American LNG companies did not enter into this crisis with clean balance sheets.

U.S. shale production will be hurt by the price crash. But it will not disappear. As demonstrated by the 2014–2016 oil market crash, prices drops will lead to mergers and acquisitions; larger companies generally can endure the oil price cycles better than smaller companies. Thus, when demand returns, the industry will eventually return, too, albeit potentially downsized.

U.S oil firms will also suffer, likely more than other oil producers around the world. To protect U.S. companies, some have called for tariffs on the import of foreign oil. However, such a move would likely backfire. The United States cannot easily cut off foreign imports, as the types of oil used by the U.S. refining industry differ from those produced domestically. Moreover, American refiners profit by importing crude and exporting refined products. Tariffs would eat into their profits.

It is also worth remembering that over the last decade, U.S. oil has been cheaper than imports. If domestic consumers could easily switch, they would have already done so given the longstanding price incentive.

With few good options at its disposal, the Trump administration had hoped to fill the Strategic Petroleum Reserve with fresh oil purchases during this period of depressed prices. This would have had a positive impact, creating demand for U.S. producers. It made good sense to fill the reserves with cheap oil (China is currently doing so). However, Congress blocked this move, preventing its inclusion in the recent stimulus package, as certain lawmakers did not want to be viewed as supporting fossil fuels.

In the end, Washington need not worry too much about the current low oil prices. Once economic activity is restored, the demand for oil will follow. For now, taking advantage of the low price to fill the Strategic Petroleum Reserve makes good economic sense and would also grant some breathing room to U.S. producers. In addition, U.S. policymakers should analyze the implications of the potential downsizing of U.S. LNG exports for various U.S. allies around the world if this industry does not weather the current market challenges. U.S. LNG exports have enabled allies to diversify their gas supplies and lower their dependence on single suppliers, especially Russia. The current market challenges could affect this significantly.

Brenda Shaffer is a senior advisor for energy at the Foundation for Defense of Democracies (FDD) and an adjunct professor at Georgetown University. She also contributes to FDD’s Center on Economic and Financial Power (CEFP). For more analysis from Brenda and CEFP, please subscribe HERE. Follow Brenda on Twitter @ProfBShaffer. Follow FDD on Twitter @FDD and @FDD_CEFP. FDD is a Washington, DC-based, nonpartisan research institute focusing on national security and foreign policy.

Issues:

COVID-19 Gulf States Libya Russia