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 crude oil market crash was vital to economic progress in the Middle East, specifically in countries dependent on oil exports. Kuwait, Iran, Iraq and Saudi Arabia were all significantly impacted by the lower oil prices. In fact, the oil market volatility reached levels not seen since the first Gulf War.

In addition, the U.S. shale industry was hit hard by the fallout. Hydraulic frackers found the downturn devastating and implemented massive production cuts in an attempt to weather the storm. Unfortunately for U.S. shale oil companies, the exceedingly bearish energy markets of spring and summer 2020 brought on insolvency and bankruptcy.

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 market. 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. Generally speaking, as crude oil inventories grow, prices stagnate or retreat.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] Each had a profound impact on global commerce, impacting OPEC and non-OPEC nations alike.

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] and spurred volatility in the global as well as the U.S. economy.

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.

Increasing energy prices are viewed as being a component of inflation. Essentially, as oil prices rise, so do the prices of refined fuels. Given that diesel and gasoline are foundational elements in the production and distribution of most goods and services, consumer prices tend to rise.

To combat inflation and promote pricing stability, central banking authorities implement a variety of policies. These policies may include interest rate hikes, reduced asset purchases and the restriction of credit availability. In total, these actions are designed to limit the money supply to stabilise the prices of goods and services.

During periods of robust oil pricing, inflation can become an economic concern. In turn, monetary policies are adopted that can roil the markets. A timely interest rate hike, or reduction of debt purchases, can bring volatility to risk assets. Equities, commodities and forex pairs can all be significantly impacted.

Consequences Of Oil Price War

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 producers, low oil prices 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 natural gas producers filed for bankruptcy. That number represented a 379% year-over-year increase.^[6] A majority of these insolvencies were shale producers, reliant on the hydraulic fracturing of shale oil reserves.
• 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. As with any other financial crisis, companies that aren't well capitalised are likely to face insolvency.

Influence On Currency Values

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. This is one of the key attributes of nations deeply invested in the oil industry.

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] Essentially, as global oil demand dried up due to coronavirus fears, the CAD retreated versus the majors.

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.

Oil Prices Fall To Historic Lows

The Monday, 20 April 2020 trading session brought a historic plunge in the global crude oil markets. Energy traders rushed to liquidate positions in West Texas Intermediate (WTI) and North Sea Brent (Brent) crude oil futures, sending values toppling to unprecedented lows. During the 20 April session, an unprecedented event took place: the price of a barrel of WTI crude oil turned negative for the first time in history.

The negative pricing of crude oil was due to the convergence of several factors. Below is a brief synopsis of each:

• Demand: Due to widespread lockdowns adopted to combat the coronavirus contagion (COVID-19), the demand for refined fuels dissipated overnight. Travel bans decreased the need for jet fuels, diesel and gasoline. Without a defined end to the restrictions, the future demand for oil became uncertain.
• Supply: Ahead of the March 2020 COVID-19 onslaught, the oil producers of OPEC+ sustained output. When coupled with North American fracking production, the world's supply of oil held firm at adequate levels. During this period, WTI traders were especially aware of data sets released by the U.S. Energy Information Administration (EIA).
• Storage: As refinements decreased, global crude oil storage facilities were quickly filled to capacity. Without any reliable forecasts for when demand was to come back online, oil storage became scarce in spring 2020.

Each of these factors contributed to an epic disequilibrium in pricing. Ultimately, the supply/demand relationship became disjointed, placing an unprecedented demand on storage capacity. The end result was that oil became worthless for a short period of time. Although unprecedented, the negative swing in pricing showed that an energy commodity could lose all of its value on the open markets.

WTI and Brent Futures Plunge

Pricing a commodity such as crude oil is an involved undertaking. Many factors influence the market dynamic, including geopolitics, armed conflict and the macroeconomic cycle. During March and April of 2020, the Saudi Arabian/Russia price war and COVID-19 pandemic prompted a severe supply glut. The tumult came to head for WTI crude oil during the 20 and 21 April trading sessions:

• 20 April 2020: May WTI crude oil futures plunged to an all-time low of US$-37.63 per barrel. June WTI futures were also down significantly, but managed to close the session north of US$20.00 per barrel.^[9]
• 21 April 2020: For the 21 April trading day, May WTI rebounded to expire at US$10.01 per barrel. June WTI futures weren't so lucky, closing at US$11.57 and shedding 43% of the contract's market value.^[10]

During the same period, Brent futures experienced heavy selling, but nowhere near the intensity of WTI. For 20-21 April 2020, UKOIL CFDs (based on the front-month Brent futures contract), fell from US$28.06 to US$19.66―a two-session loss of 29.9%.^[3] Once again, concerns over American demand and consumption from China due to COVID-19 was a primary market driver.

Equities Market Fallout

The dramatic sell off in crude oil futures sent shockwaves through financial markets around the world. An immediate impact was felt in equities, as the values of risk assets fell precipitously. For the 20 and 21 April 2020 sessions, the energy sector led significant declines in some of the world's leading stock indices:

• CAC 40: The CAC 40 plunged, posting a two-day loss of 173.88 points (-3.8%).^[3]
• FTSE EuroTop 100: In concert with the drop in Brent crude oil on 21 April, the FTSE posted a two-day loss of 68.5 points (-2.7%).^[11]
• S&P 500: Back to back losing sessions added up to a 118.52 point loss (-4.2%) for the S&P 500.^[12]
• DJIA: The DJIA struggled mightily as energy sector losses plagued valuations. For 20-21 April, the DJIA fell by 1114 points (-4.6%) as sentiment toward U.S. large caps turned negative.^[3]

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

How Can Oil Prices Be Negative?

Until the 20 April session, the concept of sub-zero oil prices remained theoretical. But when WTI crashed into negative territory, theory became reality. Subsequently, the financial world was left to wonder how a commodity's price could be negative. For oil, the answer to that question lies in storage capacity.

Despite the announcement of record output cuts by OPEC and allied countries, COVID-19 travel lockdowns destroyed consumption throughout March and April 2020. Estimates cited fuel demand to be down nearly 30% globally,^[10] which led to enormous existing stockpiles and robust projections for future supplies. WTI crude oil scheduled for May delivery became worthless as a severe lack of storage placed extreme bearish pressure on prices. Essentially, no one was interested in taking physical delivery of crude oil amid COVID-19 uncertainty and record stocks-on-hand.

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.