Desperate times call for desperate measures. Faced with an upended market, a savage rout in oil prices since early March, and egged on by US President Donald Trump, the OPEC+ group (primarily Saudi Arabia and Russia) met virtually on April 9 to discuss output cuts to support prices.
The group agreed to cut oil output by 10 million barrels a day (mbd) — about a tenth of the global oil consumption until recently (about 100 mbd). The 10 mbd cut will be applicable from May to June 2020; it will then be reduced to 8 mbd from July to December 2020, and then to 6 mbd until April 2022.
A cut of this scale is unprecedented, but even this may not be big enough. That’s because, over the past few weeks, global oil demand has been ravaged by the coronavirus pandemic. Lockdowns and shutdowns across vast swathes of the world have cut oil demand by an estimated 25-30 per cent — that would mean a demand squeeze of 25-30 mbd. The 10 mbd supply cut announced by the OPEC+ group, even if it plays to plan, pales in comparison.
The market, primed by Trump to expect a cut of 15 mbd or more, seemed underwhelmed, and oil prices fell back. Brent oil (spot price), which had rallied in the past few days on hopes of a mega output cut deal, lost about 4 per cent after the OPEC+ meeting, and now trades at about $26 a barrel.
It could go back to the 18-year low of about $20 seen a few days back, and even fall further.
The outlook for oil prices seems poor for a few reasons. One, demand for oil is extremely weak and uncertain, and will likely remain so until the coronavirus pandemic is under control. Extension of lockdowns in major oil-consuming markets such as India could mean more demand destruction. Even after the lockdowns are lifted, it could take quite some time before things get back to normal.
Next, due to the supply glut, there is a major inventory overhang in the oil market — with onshore storage capacities fast running out and supertankers, now being used to store oil on the seas, also filling up fast.
It will take time to liquidate these inventories when demand picks up.
Also, given the frayed equations among the OPEC+ members, instances of cheating on past agreements, and complex geo-political considerations, it remains to be seen whether the planned output cut will be implemented effectively.
The Saudis and the Russians had walked away from a much more modest deal in early March; the warring parties have now been brought together again in a deal brokered by Trump, who is keen to save US shale oil businesses, many of which could go bankrupt due to low oil prices.
Already, there are signs of trouble. Mexico, part of OPEC+, has not agreed to the extent of the cuts demanded from it, and the US seems to have stepped in to bridge the gap.
Also, OPEC+ expects other oil-producing countries, too, to cut their output and supplement the deal. But the G20 energy ministers in their April 10 meeting, while endorsing the OPEC+ deal, did not mention their production cuts. Russia wants the US to also participate in the output cuts, something the latter may not be keen on, given the capitalist nature of its economy that may not be amenable to government directives. The US is saying that its output has already fallen and will continue to decline due to market forces (shuttered wells due to low prices). Russia may not buy this logic and may demand that the US cut production further.
Then, there is speculation that Russia would also expect quid-pro-quo from the US in terms of relaxation of economic sanctions imposed on it during the Ukraine dispute. How all these play out needs to be seen.
Anatomy of the rout
Demand destruction worries due to Covid-19 had already weakened oil prices from about $65/barrel as of end-December 2019 to about $50/barrel by March 5. This was despite OPEC+ deciding, in December 2019, to deepen its output cuts from 1.2 mbd to 1.7 mbd, effective January 2020 until March 2020.
But then, in its meeting on March 5, the group unexpectedly could not agree on extending its output cut deal from 1.7 mbd to 3.2 mbd to stabilise already weak prices. This sparked off an all-out price war for market share gains and pushed oil prices off the cliff — Brent sank nearly 35 per cent in just two trading sessions, from $50 a barrel to $32 a barrel. The unravelling of OPEC+ — the cartel producing most of the world’s oil — sharply worsened oil’s rout. Both Saudi Arabia and Russia blamed each other for the collapse of the deal that resulted in the roll-back of even the existing 1.7 mbd, with players no longer constrained by production quotas.
Saudi fired the first salvo in the price war by slashing its official selling price and indicating a major ramp-up in its output — from about 9.7 mbd in recent months to 12.3 mbd and further to 13 mbd, going forward. Saudi allies such as the UAE followed suit. The Russians, too, indicated their intent to retaliate by ramping up output. The game plan seemed to be to flood the market with cheap oil to garner as much market share and hurt rival producers.
Worse was to come, with the coronavirus spreading rapidly across the globe in March, resulting in many countries taking tough measures, including lockdowns, to contain it. The resultant massive demand cut, combined with oversupply, crushed crude oil, pushing it to a 18-year low of about $20 a barrel. In certain logistically challenged areas of the US and Canada, crude oil fell to lower single digits, and in some cases, even below zero, a stark reflection of the glut in the market.
All oil producers — including Saudi Arabia and Russia — will be badly impacted financially by the oil price crash, and many shutdowns and bankruptcies can be expected, especially in the US shale oil industry and in smaller oil-producing countries.
This has brought the players back to the negotiating table, despite their initial posturing of being able to manage with low prices.
Now, the demand problem for oil has become a much larger one than the supply problem, and has accentuated the rout. Even in the event of output being cut beyond the planned 10 mbd, oil prices are unlikely to revive in a hurry, until demand recoups.
That is still quite some time away and not in the control of the oil producers. In the best-case scenario, with the virus threat passing off, global economic engines reviving and with sizeable supply cuts, Brent could go again up to about $50 a barrel, over the year.
In the worst case, it could test lows of $20 or below.
Impact on economy, oil companies: A mixed blessing
The rout of crude oil is a mixed blessing for India. Given that the country meets most of its oil needs through imports (about 85 per cent), the price crash can help India’s macros by bringing down the current account deficit, inflation, subsidies and forex outflows.
The Petroleum Planning and Analysis Cell (PPAC) in January estimated that for every dollar fall in oil price per barrel, the country’s crude oil bill will reduce by about ₹11,700 crore a year. The benefit though will be tempered by the weakness in the rupee. The PPAC estimated that for every ₹1 fall of the rupee vis-a-vis the USD, India’s crude oil bill will increase by about ₹11,000 crore.
Since December, the price of India’s oil basket has crashed about $40 a barrel, while the rupee has weakened about ₹5 against the US dollar — so net-net, India could benefit to the tune of about ₹4-lakh crore a year.
But these estimates need to be weighed against the massive demand destruction of oil being seen in the country due to the coronavirus-related lockdown. India will likely consume much less oil in FY2021 than FY2020; so, the benefit of the oil crash will reduce to that extent. Also, inward remittances from non-resident Indians in West Asia — a key source of forex for India — could drop significantly, with economies in those countries being badly impacted by the oil rout. This could offset a good portion of the benefit from lower oil prices.
India though has a golden opportunity to make good use of low oil prices to fill up its storage and strategic reserves to capacity.
Bad for oil firms
Oil companies, both upstream (producers) and downstream (refiners), have been hit badly by the carnage in oil. The PSU hydrocarbon producers, ONGC and Oil India, are faced with a double whammy — multi-year low price realisations, and low demand for oil and gas due to shutdowns across industries and most vehicles being off the roads.
Reports say that demand for oil and gas is down by half or more during the lockdown period, and some refiners have issued force majeure notices to their fuel suppliers. Private oil and gas companies such as Cairn India and HOEC have also been impacted badly. Upstream companies are now seeking relief from the government in terms of rationalisation of cess, royalty and profit petroleum, and freeing up gas pricing.
The PSU oil refining companies, such as Indian Oil, BPCL, HPCL, MRPL and Chennai Petroleum, should, in theory, benefit from a fall in oil prices as it could help them improve their refining margins. But the extent of the fall in oil prices will mean big inventory losses for these companies in the short run. Also, demand for refined products such as petrol and diesel has reportedly crashed — by as much as 50 per cent — as a result of the lockdown. Refining margins are also weak.
Private sector refining and petrochemicals behemoth Reliance Industries (RIL) has also been impacted due to falling demand and weak margins for its products.
The company’s telecom business and a part of its retail business (groceries and such) though offer it some hedge in these tough times.
The performance of the oil companies in FY20 is expected to be hit by a weak show in the March quarter.
Also, FY21 could be impacted by poor performance in the June quarter and beyond.
The oil crash could also potentially delay or derail the Centre’s planned divestment of BPCL and RIL’s planned stake sale of 20 per cent in its refining and petrochemicals business to Saudi Aramco. Many global oil and gas majors may lose appetite for big-ticket acquisitions. For now, survival and riding out the storm may be on top of their priority list.
Given these unprecedented upheavals, most oil-sector stocks have been hammered on the bourses.
Some such as RIL have staged some recovery over the past few sessions, but still trade much below their highs of last year.
Valuations have corrected for most of these stocks (see table).
The ongoing turbulence notwithstanding, many of these oil companies, with their strong parentage (government backing) and financial muscle, should be able to sustain in the long run.
Companies in sectors that use oil and oil derivatives as raw materials could potentially benefit from lower input costs due to crude’s crash. These include paints, tyres, fertlisers, lubricants and textiles. But demand destruction due to Covid-19 could play spoilsport for these sectors, too.
This risk of the coronavirus-led disruption being a far bigger force than the oil crash is on stark display in the aviation sector that has been laid low with most flights cancelled.
Impact on consumers: Little benefit from the decline
Consumers are miffed that the crash of crude oil since early March has not translated into a similar fall in the prices of petrol and diesel. From about $50 per barrel on March 5, Brent oil now trades at about $26 a barrel — down nearly 50 per cent.
In contrast, the prices of petrol and diesel have dropped just about ₹1.7 a litre (about 2.5 per cent lower) since March 5 (see table).
Hurdles
Many factors — pricing mechanism, currency movements, taxes and a price freeze — have prevented the full pass-through of lower crude oil cost to customers.
One, the price of petrol and diesel in India is determined not on the basis of crude oil prices, but on the basis of prices of petrol and diesel prevailing in the international market. A formula — trade parity price (TPP) — is used to arrive at petrol and diesel prices, assuming that 80 per cent of these fuels is imported into India and 20 per cent is exported.
Demand-and-supply dynamics could be different for global crude oil and petrol/diesel, and so could be their price trajectory.
The TPP, quoted in dollars, is converted into rupees, and other costs and margins of the refiners, dealer commission, and taxes are added, to arrive at the retail selling price.
The pricing of petrol and diesel happens on a ‘daily pricing’ basis. But it is based on a 15-day rolling average rate of the international benchmarks of petrol and diesel. So, international prices reflect in India with a time lag.
Also, the rupee weakening against the dollar from about 73 on March 5 to about 76 now would also have chipped away at the potential price cuts in petrol and diesel.
High taxes also eat away at the benefits to customers, as has happened many times in the past.
The Centre increased excise duty on petrol and diesel by ₹3 a litre on March 14. Also, some States such as Karnataka increased their value-added tax with effect from April 1.
Static prices
Despite the above factors, petrol and diesel prices should have come down meaningfully over the past few weeks. But that has not happened.
The prices of the fuels have remained unchanged since March 16 despite the daily-pricing mechanism. There could be a few reasons for this.
Given the upheavals due to the coronavirus spread and the countrywide lockdown, the Centre may have directed oil companies to stand still on pricing of petrol and diesel.
It could also be that the Centre, through the oil companies, is marshalling financial resources to fight the coronavirus impact. From the beginning of April, with oil companies supplying BS-VI fuels across the country, they were expected to raise petrol and diesel rates by about ₹1 a litre. This, too, has not happened, and may have been adjusted against the cost benefits due to customers. It is not clear how long the prices of petrol and diesel will remain unchanged.
To be fair, petrol and diesel prices have fallen 5-6 per cent from the beginning of January. The benefit could have been higher though, with the sharp crash in oil prices in March.