Oil, the pandemic and the global economy

Global markets can handle one crisis at a time but when two arrive simultaneously, they swoon.

Shahid Javed Burki March 16, 2020
The writer is a former caretaker finance minister and has served as vice-president of the World Bank

Is the sudden drop in the price of oil in world markets as big a crisis as its sudden rise in the mid-1970s? The one almost half a century ago badly hurt oil-importing countries, in particular those in the developing part of the world. For them oil was an important component of their import bill. Not being able to finance the sharp increase in the price of oil, these countries borrowed heavily, thus creating a serious international debt crisis. The debt crisis of the 1970s stretched into the 1980s and affected large regions such as Latin America and East Asia. Washington took the lead in bringing changes in the structure of the international system. A new facility was created within the International Monetary Fund (IMF) to quickly provide relatively cheap money to the affected nations. No such leadership can be expected from Donald Trump’s America.

Global markets can handle one crisis at a time but when two arrive simultaneously, they swoon. This is what is happening at this time. To begin with, there is the coronavirus pandemic. On March 11, the World Health Organization (WHO) gave the spread of the virus the name of pandemic. That means it spreads easily and widely. It asked its member governments to take steps to reduce the spread. The disease has already caused disruptions across the globe. China locked down Wuhan, a major industrial city on the Yangtze River with a population of 11 million people. The authorities restricted the movement of people living in the city both leaving it or within it. Italy has done the same but not in one city but for the entire country. Stopping travel to and from the country would seriously hurt the tourist trade in Italy. Tourism accounts for 13% of Italy’s gross domestic product (GDP). Even if that is cut by one-half, it would have a devastating impact on Europe’s fourth largest economy and its still fragile banking system. Italy is not the only country to be affected by the likely decline in international tourism. On March 11, New Delhi decided to suspend all tourist visas until at least the middle of April.

But when all this was going on, two of the world’s three largest producers of oil couldn’t agree on the quantities they should bring out of the ground and put them on the world markets. A significant share of the global supply comes from three countries — the United States, Saudi Arabia and Russia. The fact that the US has moved from being a large importer to one that now exports significant quantities is one reason for the uncertainty that is affecting the world oil market. But the current turmoil is the result of a major disagreement between the other two large producers — the Kingdom of Saudi Arabia and Russia.

What had once been called a “union until death do us part” suddenly collapsed as nationalist forces in Russia won the domestic debate over the price of oil. Moscow and Riyadh had determined that keeping the price of traded oil low was in their interest. That policy had been opposed by Igor I Sechin, the head of Rosneft, and a close associate of President Vladimir Putin. Both had known each other since they were junior officials in the 1990s in St Petersburg. Sechin and others in the nationalist camp believed that keeping oil prices high only helped the US where natural gas and oil extracted from shale had turned the country into the world’s largest producer of hydrocarbons. That policy hurt Gazprom, Russia’s state-owned energy giant, and also Rosneft. These two state enterprises are the two pillars of the Russian state sector.

The agreement between Russia and Saudi Arabia was aimed at putting a floor under the price of oil but Sechin and his nationalist associates maintained that that approach only helped companies in the US. These had developed and used technologies that allowed them to reach deep down into the earth, crack rocks that held oil and bring it to the surface. These technologies were economically not viable if the price of oil dropped below $40 a barrel. Also worrying was the loss of important markets in Europe and East Asia to the Americans. In January 2020, the US announced plans to export crude to China. The Chinese market was being eyed by the Russian enterprises that were planning to exploit the vast but costly-to-reach deposits in Siberia. However, the cost of extracting oil from the Siberan underground was more than $60 a barrel. The Saudi cost was only $10.

The Saudis and the Russians met in Moscow but couldn’t agree on production quotas. Alexander Novak, the Russian oil minister, returned to Moscow for consultations. According to one assessment, “the standoff was ominous for the industry. Not had OPEC and a wider group of producers — known as OPEC plus — failed to agree on new cuts, but they had also failed to sign off on an extension of 2.1 million barrels a day in previous trims that would expire at the end of March. That created a danger of tremendous flow of oil coming onto a market that was already hugely oversupplied and experiencing a steep slump in demand.”

The Russians and the Saudis have had difficult relations ever since Moscow joined the OPEC discussions without formally becoming a member of the organisation. These discussions are recounted in Out of the Desert, a book by Ali Naimi, the longtime Saudi oil minister who went into retirement a few years ago. According to him, the price large producers settle upon reflects the imperatives of domestic policy. Naimi has been succeeded by Prince Abdulaziz bin Salman, the half brother of Crown Prince Mohammed bin Salman. The Crown Prince is keeping a close watch on matters relating to oil. The Saudis absorbed most of the cuts, a situation that caused tension in Riyadh.

The uncertainty brought about by the accelerating pace of the twin crises has caused a great deal of worry in financial and economic circles. As recently as January 2020, United States Federal Reserve officials expressed the worry that “financial imbalances — including overvaluation and excessive indebtedness — could amplify an adverse shock to the economy.” That shock came from an unexpected source — a virus. The two shocks together have unsettled the financial markets. In early March, various indices reflecting the thinking of investors in the US have gone through wide fluctuations. The risk is that a wave of defaults and bankruptcies in the oil sector may start a chain reaction and impact on the parts of the economy that were already weakened by the coronavirus crisis. The two crises are acting and reacting on one another.

Published in The Express Tribune, March 16th, 2020.

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