A Perfect Pandemic Storm: The COVID-19 Energy/Oil Crisis Explained

Photo by Prexel via Flickr

Over the last few weeks, cases of COVID-19 (the novel coronavirus) were discovered and the disease began to spread internationally. Flights have been cancelled, entire cities have been put on lockdown, and economic activity in many places has slowed to a crawl. As the virus spreads, schools and businesses will close, and the risk of recession will increase. This slowing of economic activity has led to a dramatic decrease in energy demand. This is made worse since the epicenter of the outbreak is the energy demand behemoth of China. As a result, oil prices began to decline. Prices then plummeted after a decision by some of the largest oil producers (specifically, Russia) to not cut supply even in the face of this demand crisis. The COVID-19 Energy Crisis culminated Sunday evening, when the largest one-day slide since the 1991 Gulf War occurred, stoking fears of recessions or worse.

What Happened?

Energy is a unique sector since it affects all other parts of the global economy, as all economic activity requires energy of some kind. A pandemic is a “perfect storm” situation that disproportionately affects energy demand as a result of decreased economic activity, while also uniquely hurting especially energy-intensive industries like airlines, manufacturing, shipping, and transportation.

Demand Slide

This decrease in demand for energy started a slide in prices in mid-February, falling from around $55/bbl to about $45/bbl. A $10 drop is fairly significant, especially when oil majors like BP and Exxon have been planning for 2020 around that $55/bbl number. Once into the low $40s, oil is nearing the breakeven price for most upstream (exploration and production) American companies. As a result of this slide, in early March, the Organization of the Petroleum Exporting Countries (OPEC) began planning production cuts from their 14 member states to prevent further price decline.

Russian Meddling

OPEC countries produce about 44% of oil worldwide, but a crisis of this scope and scale requires larger global cooperation. OPEC began to negotiate with Russian oil producers to get them to reduce production as well. For reasons that are not currently clear (other than perhaps an effort to drown out American oil & gas companies), Russia rejected all demands for production cuts, after considering a cut of 600,000 bpd. As one Forbes contributor asked in his headline, “What Was Russia Thinking In Refusing To Cut Oil Production?” As an additional obscene gesture to the American energy industry, Russia promised to actually increase production. This was a shock to the energy markets and commodities traders, as supply controls were going to be ultimately ineffective in the face of COVID-19 demand reductions. Oil almost immediately plummeted this weekend to near $30/bbl.

Recession Indicators

Because energy is such a significant aspect of the global economy (upstream oil & gas alone accounts for almost 4% of world GDP), investors read this as a leading indicator of how rough the markets are going to be as a result of the COVID-19 crisis. Stock markets have been falling this week at a rate not seen in a decade, which for those of us who may not remember the 2008 financial crisis, ended poorly. Energy companies were uniquely hit, and saw stock prices fall as much as 15% in one day.

Why Are Low Oil Prices a Problem?

While traditionally, low (within reason) oil prices have been good for the American economy. This was due to decreased gasoline prices and overhead costs to businesses. However, we are now in the era of “Energy Dominance”, and and lower oil prices will hurt one of the fastest-growing sectors of the American economy. As a result of the shale boom, American energy production has increased considerably, to the tune of doubling American crude oil production in less than a decade. America is now a net exporter of oil and gas, and is significantly less reliant on imports of energy from abroad. In layman’s terms, if you’re selling a product, you want the price demanded for it to be higher. If you are buying a product, you prefer that it is lower. It is not quite that simple since the reasons we export or import various energy products are myriad. This is further complicated by the fact that it is hundreds of private companies trading the commodity rather than one, unified “America” buying oil, but the lay explanation is helpful to understand the current moment.

To add to those macroeconomic trends, the immense size and growth of American energy has changed the microeconomics as well. Domestically, the ripple effect from American energy woes throughout the economy will be far worse than any cheap prices at the pump can compensate for. Like I stated above, energy is upstream of the rest of the economy, so it is intuitive that cheap energy will help the rest of the economy. However, the combination of how significant energy is to the larger economy and the increasing likelihood of recession (which the low energy demand may be an indicator of) means low oil prices are a uniquely awful economic reality.

What Can Be Done?

In light of this drop in oil prices, Russia and China must immediately be brought to the table to reduce production in line with the demand drop from the pandemic. This may be difficult since Russia’s breakeven price is much lower than American companies’, and Russia has spent 5 years in austerity preparing for potential sanctions, making them uniquely well-positioned for a price drop. China will also be difficult to convince. There are ongoing complications of the U.S. trade war and they are handling being the center of the coronavirus outbreak. But mostly, they import significant amounts of oil and gas, thus benefiting from lower prices.

Art of the Deal

Despite that difficulty, there is no excuse for the most powerful nation on Earth with the largest energy industry in human history to be held hostage by the likes of Vladimir Putin and his oligarch friends. President Trump and his representatives must bring all of these parties to the table, and demand a production cut even more significant than the one OPEC requested to account for the damage to the global economy since they rejected it. If there was ever a moment for President Dealmaker to work his magic and possibly prevent a recession, it’s now.

The U.S. Department of Energy (DOE) must also cancel all future sales of oil from the Strategic Petroleum Reserve for the time being. Any supply increases that are avoidable should be cancelled immediately. DOE should encourage its counterparts around the world to also hold onto their petroleum reserves until prices recover.

What Will Happen Next?

Oil & gas production companies are already hurting, and this crisis just makes matters much worse. Over the past 5 years, production has expanded dramatically in shale oil. Often that has not brought sufficient profit margins to satisfy investors (who are especially wary of fossil fuel investments due to concerns about climate change). Since shale oil & gas is a somewhat nascent industry, capital expenditures for domestic production are quite high, leaving significant capital and debt exposure.

CapEx Damage

For the last decade, oil prices have remained sufficiently stable despite increased supply. This is largely due to increased demand abroad from growing economies in a worldwide bull market for the last decade, which may be at risk. Many of these producers are still heavily reliant on credit to build production capacity and conduct drilling exploration, making matters even worse. With these dramatically lower prices, in the short term we will see significant cuts in capital expenditures from American shale companies, severely hurting the economic growth of areas seeing booming times in recent years.

Credit Questions

If prices remain below breakeven for the medium term, companies will have to dip into credit, which remains cheap due to low interest rates. However, that debt may begin to pile up quickly and credit markets may struggle with liquidity in the face of an international economic crisis. Most experts predict that if prices remain this low for more than a few months, we may be looking at widespread bankruptcy from shale production and upstream companies. Russia is hoping that the low prices will effectively drown out American producers, thus limiting their international competition. That just might work.

Clear-Eyed Solutions

Speculation aside, leadership and decisive action will be vital from industry and policymakers alike. Industry leaders need to create a plan of how they are going to operate if prices remain at crisis levels, and find ways to regain stability in energy commodity markets. Fiscal policy will be vital, and leaders need to ensure credit is available to those who need it and that preventative measures happen to prevent mass-default on existing debt. A payroll tax cut is not going to prevent a recession, and a recession may be the death knell of many energy companies if compounded by low oil prices. Policy leaders need to bring international leadership to the table and create global solutions to this global problem.