How Does An Oil Price War Impact The Markets?

On 8 March 2020, Russia and Saudi Arabia initiated the first large-scale oil price war since 2014. Following a breakdown of negotiations between the OPEC+ members, there were extreme price cuts and production hikes. Subsequently, global oil values swiftly collapsed, led by a sudden 33.8% loss in U.S. benchmark West Texas Intermediate (WTI) crude oil futures.[1]

The price destruction of the 8-9 March 2020 trading session was not confined to the energy complex. Global equities also experienced heavy selling, headlined by a record-setting crash in the U.S. stock indices. The Dow Jones Industrial Average (DJIA) and Standard and Poor's 500 (S&P 500) each fell by more than 7%.[1] At the time, the 2000-point downturn in the DJIA marked its largest-ever single day loss. Conversely, safe-haven assets gained traction as gold, Swiss francs and government bonds became popular among risk-averse investors.

On the surface, one is inclined to believe that an oil price war is good for business. Affordable energy products can certainly spur economic growth, industrial production and consumption. However, as the March 2020 standoff between Russia and Saudi Arabia illustrated, plunging oil prices bring a collection of unique questions and uncertainty to the marketplace.

What Is An Oil Price War?

The financial definition of a price war is "an instance in which powerful competitors try to usurp each other's market share by progressively reducing prices until one retreats."[2] In the case of the global oil complex, producing nations engage in such an arrangement via the following devices:

  • Price cuts: Producers always have the option of reducing prices to some or all of their buyers. This was a key tool used by Saudi Arabia in March 2020, where immediate US$6 and US$8 per barrel discounts were offered to customers in the United States, Asia and Europe.[3]
  • Increase production: Oil prices largely depend upon the traditional supply/demand relationship. Thus, one way of devaluing crude oil is to boost production and create a surplus or "glut" of oil on the market. Throughout history, controlling output has been the primary supply-side method of influencing oil prices.

Price wars are an overtly aggressive policy, typically relegated to disgruntled producers or desperate nations. Often, the economic damage caused by these cycles can be severe. Due to this fact, only four major price wars have been carried out in the modern era: June 1985, November 1997, November 2014, and March 2020.[4]

In each instance, Saudi Arabia instituted a series of price cuts and production hikes designed to place added pressure on competitors. For the price wars of 1985, 1997 and 2014, the situation lasted more than one year. Further, crude oil was devalued by at least 50% on the global market.[4]

What Is An Oil Price War's Impact On The Markets?

Conventional wisdom suggests that crude oil is the "lifeblood" of economic development. As the essential building block for refined fuels, crude's price directly impacts the transportation, travel and manufacturing industries. Upon its availability being limited, high prices frequently ensue and there's added pressure placed on businesses and consumers.

Historically, rising West Texas Intermediate (WTI) and North Sea Brent (BRENT) prices have led to slower gross domestic product (GDP) growth rates. Sharp spikes in oil prices preceded the 1990, 2001 and 2008 U.S. recessions.[5] Conversely, a reduction in pricing doesn't necessarily hamper economic growth. Nonetheless, it may produce several consequences:

  • Short-term volatility: A precipitous drop in prices often drives volatility in related markets. Valuations of energy sector equities offerings commonly suffer, as do the currencies of oil producing nations.
  • Industry consolidation: For commodity producers, a downturn in pricing can be devastating. Companies that specialise in drilling, exploration and related services suffer greatly from an extended period of price depression. In 2015, amid a price war, 67 U.S. oil and gas producers filed for bankruptcy. That number represented a 379% year-over-year increase.[6]
  • Regional pressures: Regions reliant upon oil production and exportation are subject to dire consequences stemming from price wars. Stagnant GDP growth, lagging exports and an exodus of private enterprise are all probable occurrences.

While a prolonged uptick in crude oil prices works to slow aggregate economic growth, depressed valuations have a largely sectoral impact. The implications can be dire for those participating in the energy industry as corporate bankruptcies and layoffs are prone to increase.

In addition to the negative effects on the energy industry, oil price wars can greatly influence the currency values of producing nations. These exchange rates typically exhibit a positive correlation to the price of oil; as prices fall, exchange rates typically follow.

A premier example of this phenomenon is the behaviour of the Canadian dollar (CAD). Canada generates 5.50 million barrels of oil per day (5% of aggregate global output) and ranks as the fourth-largest producer in the world.[7] As illustrated by the CAD's performance during the Saudi Arabia/Russia March 2020 price war, the degree of forex market fallout created by a plunge in oil's value can be significant. For the month of March 2020, the CAD lost 4.8% against the USD and by 4.7% against the euro.[3]

The currencies of producing nations Russia and Brazil also experienced devaluation during the March 8-9 oil price plunge. For the 9 March forex session, the Russian ruble (RUB) fell by more than 7% to four-year lows vs the USD.[8] The Brazilian real (BRL) fared better than the RUB in March, but it still posted a 2.04% session loss against the USD.[3]

Note: Past performance is not an indicator of future results.

Summary

While a spike in WTI and Brent crude oil prices can be catalysts for recession, price wars are also capable of sending shockwaves through the financial world. Surprise price cuts or production hikes can destabilise energy prices and disjoint the global equities and currency markets. Even though cheaper oil may stimulate long-term economic growth, short-term market turbulence and energy sector consolidation are also routine implications.

References

1

Retrieved 04 Apr 2020 https://www.foxbusiness.com/markets/us-markets-march-9-2020

2

Retrieved 04 Apr 2020 http://www.businessdictionary.com/definition/price-war.html

3

Retrieved 04 Apr 2020 https://www.fxcm.com/uk/research/forex-charts/

4

Retrieved 04 Apr 2020 https://www.worldoil.com/news/2020/3/18/history-shows-the-2020-oil-price-war-won-t-end-soon

5

Retrieved 04 Apr 2020 https://www.cnbc.com/2020/01/03/spiking-oil-prices-have-led-to-recessions-in-the-past-and-thats-why-the-stock-market-is-on-edge.html

6

Retrieved 04 Apr 2020 https://money.cnn.com/2016/02/11/investing/oil-prices-bankruptcies-spike/index.html

7

Retrieved 04 Apr 2020 https://www.eia.gov/tools/faqs/faq.php

8

Retrieved 04 Apr 2020 https://www.rferl.org/a/ruble-oil-prices-tumble-after-opec-deal-collapses-amid-coronavirus-fears/30476938.html

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