Crude oil, like many other financial assets, has been in a freefall in the last few weeks due to the advent of COVID-19.
Numerous factors have contributed to its demise, making potential investors fearful of where the floor might be. On the contrary, a lot of investors also believe this to be an unprecedented opportunity to invest in crude oil, citing its current price as an attractive entry point.
With oil prices at their lowest in as much as 18 years, it presents some interesting investment opportunities. Here, we analyze the factors that have caused crude oil’s downfall, the factors that will be responsible for its price in the next few months, and whether or not investing in crude oil is the correct move.
How Crude Oil Price is Determined?
Simply put, the price of crude oil is determined by global supply and demand. When the global economy is growing, there is an increased demand for crude oil, especially in developing countries.
The demand is based mainly on power generation, airline travel, and fuel for vehicles.
However, supply and demand is not the only factor. OPEC is able to influence oil prices by limiting the amount of production per member. With 41% of total global supply being produced by OPEC members, this impacts the price of oil significantly. Saudi Arabia, particularly, has been able to sway oil prices by altering its production rate.
That said, there have been numerous instances of countries refusing to follow the quotas imposed. Usually, countries have purposefully overproduced and caused a downfall in price.
Geopolitics plays a key role in oil prices
As we saw the OPEC oil embargo of 1973 ravage the US economy and quadruple the price of a single barrel. The main reasons for the decline in oil prices in 2020, for example, has been a price war between Saudi Arabia and Russia and the decrease in in demand due to the ongoing effect of the Pandemic.
Lastly, Oil is mainly traded through futures contracts. This means that speculators and hedgers also have a significant impact on oil prices. Market sentiment can play a key role in determining prices. If speculators believe that prices will fall in the future, they may sell their contracts and the price may fall earlier, creating a self-fulfilling prophecy.
How COVID-19 Has Impacted Crude Oil – The Present
The rapid fall in the falling prices of crude oil has been due to two main reasons. The first one was the global pandemic reducing demand. However, a price war between Saudi Arabia and Russia exacerbated the crisis and prices continued to plunge.
Let’s take a look at them individually.
Social Isolation and Lockdowns Across the World
In January, the effects that COVID-19 would have on the world economy started to become apparent. Since then, the prices of crude oil have been falling steadily, with a huge decline on March 9.
The main reason for the fall in prices has been, quite simply, a demand shock.
As the imminent dangers of COVID-19 became apparent, governments across the world started to recommend social isolation. Many countries, especially in Europe, imposed a lockdown that seriously inhibited movement and shut down businesses across the country.
With people being unable or afraid to leave their homes and the vast majority of non-essential businesses shut, there wasn’t a need for crude oil like before. Not only was energy being saved, but the need for gasoline also declined with numerous countries banning air travel and discouraging land travel. This is evident from the effect that COVID-19 has had on pollution.
The change in oil price was quick and drastic. On April 21th we’ve seen a historical event – prices turned negative, dropping as low as -$40.32 per barrel before settling in the negative thirties (and go back to about $20 these days).
Price War Between Saudi Arabia and Russia
With falling demand, it was quintessential to cut the supply as well in order to maintain oil prices.
However, countries across the world continued to produce oil in full-force. Eventually, it was obvious to everyone that oil production would need to be cut.
However, Saudi Arabia and Russia failed to reach an agreement over the March 8 weekend on a reduction in output. As such, Saudi Arabia decided to massively increase its production and launch a price war. On March 9th, we saw the oil market crash 30% within seconds of opening.
This is a similar situation to the one we saw in 2014. The demand failed to keep up with expectations. As such, prices crashed in the summer and prices fell from $115 a barrel to around $70.
The price war essentially added fuel to the fire and greatly increased the rate at which the prices tumbled. However, the future of crude oil may very well be different from the present.
The Future of Oil Price
After the dust settled, West Texas Intermediate, the benchmark for US crude oil had fallen below $20, its lowest price in almost 18 years.
That said, the oil industry is beginning to change.
Producers are starting to realize that the COVID-19 pandemic may not let up any time soon. This means that demand will continue to be low for the foreseeable future.
As such, a reduction in supply is necessary.
1. OPEC+ Announces a Cut in Production
On April 12th, OPEC+ (which is an organization comprising of OPEC as well as a few other nations) announced that it will cut oil production by 9.7 million barrels a day. Most analysts still believe that it is not enough, and the deal failed to impact the price as OPEC+ members had hoped.
However, this is only the beginning. The US government has been contemplating cutting its own supply. However, oil producers are unable to come to a conclusion on what the best course of action is. While reducing production may increase prices, it will also cause hundreds of thousands of jobs to be lost.
At the very least, it is obvious that further production cuts are being considered. If further cuts occur, chances are that crude oil will rally.
This seems to be the reason for oil prices stabilizing, with WTI hovering around the $20 mark.
2. The Decline of COVID-19
The major cause of crude oil’s decline was the loss of demand due to COVID-19. Eventually, the pandemic has to end and the world economy will slowly start to return to normal.
When that happens, crude oil will experience a sharp rise in demand. Sadly, it is improbable that demand will return to pre-crisis levels immediately.
This is because it will take time for normal business activity to resume and for income levels to rise. Chances are that unemployment will be much higher than it was previously, thus leading to a decrease in consumption.
3. Speculation and Hedging
While this is not as huge a factor as the aforementioned two, it’s still there.
At some point, the price of oil has to be considered low enough to be a worthwhile investment.
That is when speculators will jump in, and help prop its price up by increasing demand.
Also, when business activity resumes, oil users worrying about an increase in price will probably want to hedge themselves, which will prompt them to purchase futures contracts in droves. If this happens, then we will see a slight increase in oil prices in the short-term as well.
What About Oil Stocks?
A decline in crude oil prices has had ramifications for stocks as well. With 3% of the S&P 500 comprising of oil companies and banks exposed due to loans, a fall in crude oil price has also lead to a decline in the stock market.
The Energy Select Sector SPDR, which is mainly made up of huge oil corporations such as Exxon, has recovered in a much better manner from its lowest price in the second half of March.
The main reason for this is that the market believes that larger oil companies are not threatened in a huge manner from the decline in oil prices. Eventually, the prices will rise once again and corporations will be able to increase their profits once again.
Another factor here is that if smaller companies do go bankrupt, then larger organizations will be in a prime spot to acquire such companies. This will only increase their revenues in the long run.
Those who are bullish on crude oil should probably diversify their oil holdings by investing in oil companies. Investing in an ETF such as the Energy Select Sector SPDR is a great way to diversify your stock holdings across multiple companies.
Crude oil has had a tumultuous 2020 so far. The COVID-19 pandemic caused a drastic reduction in demand. Production cuts failed to keep up, and a price war further caused oil to hit its lowest price in almost two decades. Stocks of oil companies faired similarly.
However, the future seems to be better. While there is no clear indication of when the pandemic will subside, it is a virtual guarantee that it will eventually fade away. When that happens, oil prices should gradually start to rise.
It is very difficult to predict crude oil prices in the short-term, especially until the US government decides on whether or not it should cut its production levels. However, crude oil and large-cap crude oil stocks seem to be a viable investment in the long-term!