In a move that surprised energy markets, Saudi Arabia decided to pump more oil and bring prices down, radically breaking negotiations within OPEC members and Russia over production quotas. The impact was immediately felt, with crude oil prices declining by up to 34% and leading several stock exchanges to a halt.

As an energy policy and business researcher, and professor of the ASB course “Energy: markets, policies and sustainability,” I have been asked by the media and other stakeholders on my thoughts of this move that surprised many. In particular, why this happened? And what does it mean for the global and Malaysian economy and energy industry?

WHY OPEC+ FAILED TO REACH AN AGREEMENT

With prices floating around $60 and below, Saudi Arabia and OPEC partners have been trying to get Russia’s cooperation to production cuts in order to bring prices up. OPEC is responsible for about 42% of world oil production and Russia, alone, for another 10% of the 100 million barrels of oil per day of world output. So to get Russia onboard with a new round of production cuts was critical for the cartel to bring prices up.

However, Russia preferred to not do it, fearful of cutting production would only cede market share to other producers outside of the arrangement, like companies that extract oil from shale in the United States or deep offshore from Brazil, where production has been booming. For many years, only Saudi Arabia showed leadership to lead production cuts and try to sustain an above-market price.

It does so with a big cost: maintaining idle infrastructure in terms of spare capacity, wells that are ready to produce but stay put, and losing market share to other producers who do not need to cut. Costs and risks disclosed during the Saudi Aramco IPO which we discussed in class, for example. What happened this weekend is that Saudi Arabia got tired of trying to sustain production cuts alone, without the help of another major producer like Russia, and decided to open the spigots.

It has happened before in the mid-1980s, in 2014, and now again in 2020. It is related to a fundamental problem of managing a cartel of producers: everyone benefits from higher prices, but benefit the most those who keep selling all they can while the rest reduce their output. Now, Saudi Arabia is punishing their partners by showing that if they do not come on board, the Saudis will flood the market with oil and the rest will lose. This is the supply side of this price shock.

COVID-19 AND A DEMAND SHOCK

To make matters worse, we are also living a demand shock. Already at the beginning of the year there were signs of an oil glut – excess capacity in comparison to a slower demand growth. After the Covid-19 outbreak, the situation only got worse. The International Energy Agency estimates that, for the first time since 2009, the oil demand will fall compared to the previous year.

The Covid-19 has been showing to be not just highly contagious for human health, but also to the globalized economy. Countries and firms are reacting to the virus by quarantining people, making them work from home, cancelling events.

These decisions are a direct hit to the transportation sector which is the most oil intensive. About 29% of all energy consumption is used by the transportation sector and almost all of it (96%) comes from oil. The longer the virus is among us and social distancing measures are adopted, the greatest the impact to a key consuming sector of the oil industry.

IMPACTS TO MALAYSIA

As an economy dependent on the oil industry, few sectors of Malaysia stand to win from a drastic fall of prices. Instead, the combination of economic slowdown from the Covid-19 and low oil prices will make it a tough year for the Malaysian economy.

First, the fiscal impact can be quite negative. In 2019, an estimation by the Ministry of Finance pointed out that every US$1 of oil price increase could add about RM300 million to the budget. The 2020 budget was designed with a forecast of a $62 oil price and Saudi’s decision led the barrel to be traded at $30s. Therefore, a drop of $30 would create a budget shortfall of about RM9 billion in one year.

This is almost half of the RM20 billion stimulus package recently launched. So you can face a situation of having less revenue from economic activities because the economy is slowing down (taxes), with the oil sector reducing its fiscal contribution, at the same time that there is more pressure to increase spending and reduce the effects of the Covid-19.

The low oil price also affects another large portion of the Malaysian economy: the oil and gas supply chain, from yards to service suppliers. Some Malaysian companies have successfully expanded abroad and are doing oil and gas jobs in many parts of the world, not only here. Low oil prices reduce new investments in exploration and production and lead oil operators to force contract renegotiation with suppliers to further cut operational margins. Therefore, suppliers in the industry can also be hit by this price shock, even if their order book is healthy.

CYCLICAL, BUT NOW UNDER LONGTERM THREAT

In the near term, the oil industry, and countries that rely heavily on O&G exports for their economy, will face a double shock of supply and demand. This will likely keep prices low for some time – unless OPEC partners come back to the table and bargain with Saudi Arabia to reduce production. In the medium-term, low prices reduce investment in exploration and production, putting into risk future capacity.

Every year, the global O&G industry needs to find and develop an additional 3 million barrels of oil per day just to compensate for the natural decline from aging fields. The catch is that it can take a considerable amount of time to bring new supply capacity to the market. For example, a deep offshore field can take up to 10 years from area acquisition to first commercial production.

With low oil prices, operators cut back investment now, and when demand start to ramp up again, the supply may be tight, a dynamic that can bring prices up again. That is why oil prices are so cyclical and this is a risky business. However, there are good reasons to think that we may start to depart from this “business as usual” scenario. A combination of declining prices and policy activism against climate change is making renewable sources of energy more competitive each day.

The rapid growth of electric vehicles (EVs), which are much more efficient than internal combustion engines (ICEs), along with declining battery cost, can radically transform oil’s golden market share which is transportation. A study by BNP Paribas calculate that the combination of falling cost of renewable energy generation from wind and solar and EVs (which are essentially “batteries on wheels,” providing a solution to the intermittency problem of renewables) can be drastic to the oil business.

The study calculates oil’s long-term break-even price to be competitive with EVs (in terms of how much mobility you can buy) to be between $11 and $20. If that proves to be true, the current oil price will turn out to be rather expensive than cheap.

In the ASB course “Energy: markets, policies and sustainability,” we cover the economics and politics of energy markets and the likely impacts of different scenarios. Our students come out of it prepared to react and become leader in their fields by recognizing how the energy industry is being affected by technological changes, geopolitical and policy pressures, and also seemingly surprising (but not unprecedented) events, like what happened this week following Saudi Arabia’s decision.

Prof Renato hails from Brazil and received his PhD in Political Science from MIT. He is a resident faculty member teaching the MBA program at the Asia School of Business.

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