The Policy and Politics of the COVID-19 Oil Market Crash
Two energy economists discuss supply, collusion, jobs, and the impact on gasoline prices.
This week’s blog post is a podcast. Last Wednesday, I sat down (from a safe 2000 mile distance) with University of Chicago Professor (and Energy Institute alum) Ryan Kellogg to talk about how the sudden downturn in oil demand is affecting oil policy and politics in the US.
Here are some excerpts, but there is much more in the podcast.
Effect of the price crash on US production from existing wells and drilling of new wells
RYAN: “To profitably drill and frack a new well you need something in the neighborhood of $40 oil. So in terms of new drilling, what we’re going to see in the US is drilling of new wells basically go down to almost zero.” The effect on oil production will be primarily from the freeze in new wells, which will show up “later into spring and certainly in the summer.” But, “If prices stay at $20 and don’t go much lower, my guess is you’re not going to see a huge change in production from existing wells.”
How should US policy on the Strategic Petroleum Reserve (SPR) respond?
SEVERIN: When oil futures markets are in extreme contango, with two-year-out futures prices nearly twice as high as spot prices [Since we recorded, the difference narrowed. The two-year futures price was about 30% higher than spot at the close on Friday.], this price trajectory creates “some pretty strong economic arguments, regardless of the political motivation of supporting the price of oil, just for the government to make some money storing oil in the SPR.”
RYAN: “It’s an awful lot cheaper than putting oil in a tanker offshore, on rail cars, or all the other things folks are doing in the private market.
Should the US collude with OPEC and Russia?
We each found the fact that the federal government and Texas are seriously considering colluding to raise prices above competitive levels pretty shocking. And also bad for the US economy.
RYAN: “It looks like the market is actually being globally competitive, at least for the time being, which seems like something we should be celebrating rather than trying to push and cajole Saudi Arabia and Russia back into collusion, let alone collude with them.”
SEVERIN: “If our oil costs $40 a barrel and the Saudi oil costs $10 a barrel, and we managed to get oil back up to $50 a barrel, almost all of the rents are going to the Saudis, because while US oil producers would be able to profitably produce, they would be making rents of say $10 a barrel and the Saudis would be making far, far more.” “Our consumers would be paying much more for all of the oil, but most of the rents would not be going to US producers. They’d be going to producers elsewhere.”
Downstream price impact: A bigger drop in wholesale gasoline than diesel or heating oil
SEVERIN: “We’re also seeing gasoline prices drop in some ways even more drastically [than oil] at the wholesale level. It hasn’t come through to retail yet, but wholesale prices…are generally in the 35 to 50 cents a gallon range, which means that gasoline is actually selling for about the same or slightly cheaper than the oil that goes into producing it. It seems that part of what’s going on is the split between heating oil/diesel production and gasoline production because diesel hasn’t fallen nearly as much.”
Regional economic impacts, and jobs
RYAN: “People in the industry are being laid off…That’s an argument for doing the things we’re doing in the stimulus bill across the rest of the economy.” “These are not arguments for artificially inflating the price of oil which won’t do much to bring back jobs.”
SEVERIN: “It’s essentially bailing out mostly shareholders of oil companies…I’m sorry for everybody who’s losing money, but they shouldn’t be at the front of the line when we start thinking about who needs help through this crisis.”
To hear the full discussion (about 19 minutes), listen to the podcast
Ryan also posted an excellent related op-ed at Forbes.com on Friday.
We hope you are staying safe and healthy, and we send our thanks to the healthcare and other essential workers who are taking risks to fight the COVID-19 pandemic.
I’m still tweeting interesting energy articles/blogs/research (and occasional political views) @borensteins
Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas.
Suggested citation: Borenstein, Severin. “The Policy and Politics of the COVID-19 Oil Market Crash” Energy Institute Blog, UC Berkeley, April 6, 2020, https://energyathaas.wordpress.com/2020/04/06/the-policy-and-politics-of-the-covid-19-oil-market-crash/
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Severin Borenstein View All
Severin Borenstein is Professor of the Graduate School in the Economic Analysis and Policy Group at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He received his A.B. from U.C. Berkeley and Ph.D. in Economics from M.I.T. His research focuses on the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. Borenstein is also a research associate of the National Bureau of Economic Research in Cambridge, MA. He served on the Board of Governors of the California Power Exchange from 1997 to 2003. During 1999-2000, he was a member of the California Attorney General's Gasoline Price Task Force. In 2012-13, he served on the Emissions Market Assessment Committee, which advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. In 2014, he was appointed to the California Energy Commission’s Petroleum Market Advisory Committee, which he chaired from 2015 until the Committee was dissolved in 2017. From 2015-2020, he served on the Advisory Council of the Bay Area Air Quality Management District. Since 2019, he has been a member of the Governing Board of the California Independent System Operator.
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There are competing issues in this. On the one hand, a short term view says low gas prices are good for consumers. However, that view is truly short-sighted.
We have about 30 years left until the world is mostly weaned off of fossil fuels for energy (I’m reasonably certain there will be a niche market for a decade or so following, if only because the products can be used for other purposes like rubber and plastics). From a national self-interest perspective, there is value in assuring an uninterrupted supply to the stability of our economy, and also to the military security (our military still runs on fossil fuels). These low prices may well cause the bankruptcy of our fledgling shale oil companies, and once they have failed we will be vulnerable again to prices skyrocketing the other direction.
I generally don’t like subsidies or protections of any kind, but in this case a modest protection may be in order. Set a tariff on oil imported from countries other than Canadian shale oil and possibly Mexican resources such that it sets a “floor price” for the product high enough to ensure our young businesses can continue to meet payroll and pay their bank notes. Once the trade war between Russia and the Saudis is over, prices will likely rise above that level again – and life will go on as normal. Such a tariff would still leave gas around $2/gal at the pump – hardly excessive to secure our national interests and security.
Another timely discussion. Generally speaking, a market economy should be the mechanism to balance supply and demand for oil and not collusion. Government assistance provided through an economic stimulus should be tied to developments and guarantees on the regional economy and the climate. The following comments may help explain the position I take on this issue:
1. I agree that the global oil market today is competitive. It is important to point though that the market has become more competitive and contestable with the entry of US fracking and particularly since 2016 and not before. World oil supply / demand is of course subject to world demand for oil, the health of the world economy, expansion and contraction of oil production capacity, etc. But a review of production data, 2016 – present, of the key oil producers: OPEC, Russia, and the US shows consistent increase in US production, fluctuation in Russian production, and significant loss of market share by OPEC. We should also note that increased production was coming not only from the US but also Brazil, countries entering oil production for the first time, etc. But the US production increases were the biggest of all resulting in persistent oversupply of the market. This was the period during which OPEC and Russia’s attempt to counter US increased production was made using production cutbacks to maintain a higher Brent oil price. It resulted in a relatively higher oil price but a loss of market share for OPEC and vastly increased US oil production.
2. The combination of a major loss in demand mostly as a result of the Corona virus and oversupply of oil is what led to the oil price collapse and the situation we have today of significant oversupply of oil. The oversupply is estimated at 10 % increasing to 20 % of all oil traded in the world. An oversupply of this size is a major concern for the world economy and not only an issue of Russian or Saudi Arabian market shares or oil revenues. Here are few pointers to keep in mind much of which have been discussed in the press.
a. If the price does not recover through some mechanism, the price can continue to drop. Last week it was in the $ 20’s. Several market observers caution that it could drop to as low as $ 10.
b. Such prices even if they were to hold for a short time would have an extensive impact on:
i. The economies of oil producing countries
ii. The US particularly Texas, Pennsylvania, South Dakota, and Alaska
iii. The economies of developing countries making entry into the oil business: Kenya, Tanzania, Chad, Guyana, Vietnam, etc.
c. A low oil price, however, can counteract the effect of the virus on the world economy and subsequent recovery reducing the impact of an economic recession.
d. A low price is severely impacting the oil majors: delayed and cancelled expansion projects, reducing or eliminating dividends, and the outlook for asset sales, stranded assets, and mergers and acquisitions. A comeback can be difficult with lower share prices and reduced access to capital. It is important to point though that the oil majors are in position to survive the present situation without US government assistance but with significant implication to the very identity of the oil majors.
e. A low price can devastate the fracking industry given high debt situation, an oil price close or below their short run marginal cost, and diminishing access to the capital markets. The near term outlook thus is for: no new shale wells being drilled, reduced production, bankruptcies, and M&A. Fracking would still survive but liberated of debt and under new ownership.
f. The biggest risk thus is for independent and shale US oil and gas producers and the economies of the regions they operate in.
g. A key concern is the impact of the current events on oil and gas capital projects and the strategic direction IOCs would take in the energy transition and beyond.
3. All this points to the care that should be exercised as to how the call for reduction in oil production is exercised and by whom. OPEC is a cartel. OPEC and OPEC+ countries are probably able given each country’s institutional framework to act or join in setting oil production limits outside the working of a competitive oil market. In the case of the US, the Texas Railroad Commission can legally act to constrain oil production. The question is as to how able the commission is to do that in an economically and equitable manner. A key concern for all members of the oil and gas industry particularly US is antitrust and the prospect for legal action for collusion in setting the price of oil.
Hi Severin,
One quick question. As a consumer “Do you think prices at the pump will stay low once the “Stay at Home” ban is lifted and people are back to work? and if so can you predict for how long? Thanks
According to your comments, at the existing $20 price point most fracking and new drilling is not economic. As a result, many of those producers will not only cease production many will go out of business. Your comments also address the rent differentials of any cartel activity to control production given the production cost differentials between the Saudi’s and US producers. However, you did not address the several key areas including: (1) impacts on both the production and cost of natural gas related to the potential demise of fracking and oil producers; (2) the strategic and economic implications for the US and Europe relative to Russia and China should the US again become a net importer of foreign oil,no longer an exporter and; (3) the environmental and carbon impacts when oil prices become more competitive with natural gas.
Severin, one of the more informative podcasts I’ve heard lately (the supply of podcasts in the Age of COVID seems to be mirroring crude oil, with a corresponding decline in quality). Your discussion raises questions about both supply and price-fixing for natural gas:
1) What percentage of U.S. gas comes from “associated” wells, vs. wells dedicated to extracting gas? If most is a by-product of oil wells, it seems a decline in new oil drilling could have a significant impact on gas prices in coming months, with consequences for the retail price of electricity.
2) Talk of Texas dictating production terms to independent producers raises the specter of state-sponsored price fixing. Is anyone at the Dept. of Justice paying attention?
3) Gas used to generate electricity at San Diego Gas & Electric is purchased from Southern California Gas Co. (SCG), and both are subsidiaries of the same holding company (Sempra). The electricity subsidiaries of both Pacific Gas & Electric Corporation and Edison International conduct similar affiliate transactions with gas subsidiaries of their respective holding companies. Since electricity customers ultimately pay the price of fuel used to generate it, doesn’t any profit charged by affiliated gas entities amount to price fixing?
Carl,
Shale natural gas is largely produced in association with oil production. The higher profit margin crude oil receives had throughout history led to downplay in investments in natural gas: gathering, processing, and grid expansion. This in turn have lead with the entry of fracking to increases in flaring of gas and methane emissions. The collapse in oil demand as a result of the corona virus is resulting in drop in oil demand worldwide. Lower oil production in the US is leading to lower natural gas production, lower flaring of natural gas, and lower methane emissions. This however is not likely to translate in natural gas shortages nor in significant improvements in natural gas margins.
Texas RRC legally can set oil production limits.
Anees, whether Texas RRC can legally set oil production limits is debatable, and will likely be dependent on a Supreme Court ruling. Standard Oil wasn’t allowed to manipulate prices in 1911; why should Texas be afforded that luxury in 2020?
I agree that a legal challenge can be leveled against the Texas RR. But note that the Texas RR is the regulator while Standard oil was the subject of the regulation.