July 18, 2020//-Since March, oil markets have been buffeted by an exceptional confluence of demand and supply shocks that have culminated in an unprecedented collapse in oil prices.
The COVID-19 pandemic and the measures deployed to contain its spread— quarantines, travel restrictions, shutdowns of non-essential activities—have caused severe economic dislocations.
Governments have responded with programs to mitigate personal hardship and disruptions to economic life, and central banks have cut policy rates and injected liquidity on an extraordinary scale.
Many countries have nevertheless suffered deep economic contractions, with especially sharp reductions in travel and transportation—both heavily oil-intensive activities.
The collapse in energy demand came on the heels of delays of OPEC and the Russian Federation in extending a production agreement in early March.
This was followed by outright production increases in some OPEC countries (World Bank 2020). A new agreement between OPEC and non-OPEC producers to curb production was reached in early April; however, prices fell further after the announcement.
Coupled with the collapse in global energy demand, global oil inventories have risen steeply and, by June, remaining storage capacity may be limited (IEA 2020). Oil prices have plummeted, recording their largest one-month fall on record in March.
By one measure, the European Brent spot price, the oil price fell by 85 percent between January 22, when the first human-to-human transmission of COVID-19 was announced, and its trough on April 21—more than at the height of the global financial crisis (70 percent from end-August to late-December 2008) and more than the plunge during the whole period of end-June 2014 to midJanuary 2016 (77 percent).
The West Texas Intermediate oil price fell into negative territory on April 20.2 Since then, Brent oil prices have regained some ground but, at around $30 per barrel on average in the first three weeks of May, remain less than half their January average and around the January 2016 trough of the oil price slide of 2014-16.
In the context of the current widespread and severe restrictions on economic activity to stem the spread of the pandemic, low oil prices are unlikely to provide much of a buffer for the global economy.
Indeed, there are signs that low oil prices may even be compounding the damage being done by the pandemic by weakening the balance sheets of producers.
However, high levels of inventories suggest that oil prices may remain low for some time, which may provide some initial support for the broader economic recovery once it gets underway.
Against this background, this chapter examines the likely implications of the 2020 oil price plunge by putting it in a historical context and drawing lessons from the experience of emerging market and developing economy (EMDE) energy exporters and importers during the 2014-16 plunge.
Specifically, what has been the source of the 2020 oil price collapse? • How does it compare with earlier episodes? • How will low oil prices likely affect the eventual recovery of EMDE energy exporters and importers?
.First, it is the first comprehensive analysis of the potential impact of the 2020 oil price plunge on EMDEs and the global economy.
Second, it puts the current decline into historical context to allow an assessment of the severity of the plunge. Third, it draws policy lessons from previous episodes of sharp declines in oil prices to examine the implications of the current plunge for EMDEs.
Main findings
- The steepest drop on record. The collapse in oil prices in March was the steepest one-month drop on record. A precipitous decline in oil consumption in the context of still-robust production has led to a rapid buildup in oil inventories.
By June, remaining storage capacity may be limited. • Predominantly demand-driven oil price decline. The oil price plunge since late January mainly reflected a collapse in demand arising from the pandemic and the restrictions that were needed to stem its spread.
Besides triggering a global recession, these restrictions severely disrupted travel and transport, which account for around two-thirds of oil demand.
Oil demand is expected to decline by about 9 percent in 2020—an unprecedented plunge. Supply-side factors, in particular the initial delay in agreeing to limit production, added to downward pressures on oil prices.
Output losses in energy-exporting EMDEs. This latest oil price plunge was preceded by six previous plunges over the past half-century. During past demand-driven episodes, energy exporters and importers suffered similar initial output losses (about 0.5 percent) that were unwound within three years.
In supply-driven oil price plunges, however, energy importers did not witness robust growth pickups but energy exporters witnessed similar initial output losses as in demand-driven plunges and less than one-third of these losses had been unwound three years later.
This lasting impact of supply-driven oil price plunges may reflect a reassessment of long-term prospects for energy exporters. Energy-exporting EMDEs with lower debt, more flexible exchange rates, and more diversified export bases suffered smaller short-term output losses.
- Potential support for global growth early in a recovery. As long as widespread restrictions continue to constrain economic activity across the global economy, low oil prices are unlikely to provide meaningful support to global growth.
If anything, the current episode of low oil prices holds less promise for a sustained boost to global growth than past episodes of low oil prices since energy exporters entered the current episode with eroded fiscal positions and foreign exchange buffers to support their economies, after having drawn on them to weather the previous oil price plunge of 2014-16.
That said, when current pandemic-related restrictions ease, excess inventories and low oil prices could provide some initial support for the revival of global economic activity.
- Need for policy action. Current low oil prices are an opportunity to review energy-pricing policies, including remaining energy subsidies. A carefully calibrated design, phasing, and communication of such reforms is critical for their success. For energy exporters, this most recent oil price decline is yet another reminder of the urgency to continue with reforms to diversify their economies. These include measures to strengthen competition, broaden fiscal revenue bases, and enhance fiscal and monetary policy frameworks.
Drivers of the oil price plunge
By one measure, the European Brent spot price, crude oil prices fell by 85 percent between January 22nd (the date the first recorded human-to-human infection was announced) and their trough of $9 per barrel on April 21st before recovering in May to less than half their January average.
The oil market has been hit by an unprecedented combination of demand and supply shocks. The pandemic, and the restrictions on business and personal activities imposed to stem its spread, have triggered a global recession, and a steep drop in the demand for oil.
Total oil demand fell by almost 5 percent in the first quarter of 2020, and is projected to decline 20 percent in the second quarter of 2020 (IEA 2020).
This coincided with a delay in early March of OPEC and its partners (OPEC+) to agree an extension of their production cuts (World Bank 2020).
Meanwhile, petroleum inventories have risen rapidly and are expected to reach nearfull capacity in June (IEA 2020). Demand decline resulting from lockdowns. The single largest factor driving the collapse in oil prices has been the sharp reduction in oil demand arising from government restrictions to stem the spread of the pandemic.
Many countries have implemented wide-ranging travel bans, sharply reducing the number of flights. Stay-at-home orders and a widespread shift to remote working have caused the number of passenger journeys to plummet. For example, passenger journeys in China fell by three-fifths compared to their normal level in March, while subway journeys in New York fell by more than nine-tenths in April.
There has also been a reduction in the volume of shipping, both for consumers (most notably cruises) and container shipping for industry, as a result of shrinking global trade.
The unprecedented reduction in transport in many countries—which accounts for around two-thirds of demand for oil—has led to a sharp fall in fuel consumption. Demand decline resulting from the economic downturn.
The global recession currently unfolding, which is on track to be the steepest in the past eight decades, also reduces global consumption of oil.
Declines in economic growth can lead to sharp falls in oil prices, because of the high income elasticity of demand for oil. Over the past two decades, a 1 percentage-point decline in income growth in the United States or China has typically been associated with a 13 and 10 percent fall, respectively, in global oil prices after one year.
Supply fluctuations. Oil markets have also been buffeted by production decisions by OPEC and its partners. Following several years of rapid growth in U.S. shale oil production and amid falling global oil demand, the production agreement among OPEC+ partners failed to be renewed in early March.
This exacerbated the initial decline in prices and triggered a further 24 percent fall in prices the day after the announcement. In early April, OPEC and its partners announced a new agreement to cut production by a historically large 9.7 percent in May and June that would be unwound gradually.
However, the size of the cuts was apparently insufficient to reassure markets that they would offset the decline in consumption, and oil prices fell further following the announcement.
Net effect: Oil price plunge in 2020 mostly demand-driven. A structural vector autoregression model helps decompose the oil price decline in 2020 into demand- and supply-driven factors.
The decomposition identifies a positive supply shock—such as would have been caused by the failure of the OPEC agreement in early March—as an event that lowers prices and at the same time raises both global oil output and industrial production.
In contrast, a negative demand shock—such as would have been caused by travel restrictions or falling global growth—is an event that lowers oil prices amid falling oil output and industrial production.
The decomposition suggests that two-thirds of the price decline in the six months ending in April 2020 has been due to falling demand.
Comparison with previous periods of disruptions
This time, the widespread economic weakness and travel disruptions have been associated with a considerably steeper oil price collapse than similar episodes in the past.
For 2020 as a whole, oil demand is expected to drop by an unprecedented 9 percent—more than twice as much as during any previous global recession or oil-specific demand slowdown.
Global recessions. Prior to this year’s event, there have been four global recessions over the past 70 years: 1975, 1982, 1991, and 2009 (Kose and Ohnsorge 2019; Kose, Sugawara, and Terrones 2020).
In each of these episodes, there was a contraction in real per capita global output and broad-based weakness in multiple indicators of global economic activity.
During these recessions, oil prices (and other industrial commodity prices) fell. The sharpest declines occurred during the global financial crisis, when oil prices fell by nearly 60 percent over three months. In most of these recessions, oil prices remained below pre-recession levels for several years.
Oil consumption also typically fell during these episodes. The largest decline in oil consumption occurred in 1980-82, when consumption fell by a cumulative 9 percent from its peak in 1979.
The supply-driven spike in oil prices in 1980, around the revolution in the Islamic Republic of Iran, contributed to the global recession in 1981-82, which further depressed oil consumption.
In contrast, the two most recent recessions saw much smaller declines in oil demand. For the 2008-09 recession, this reflected the strong shift in global oil consumption towards China, which continued to grow robustly through the global financial crisis (Stocker et al. 2018).
Travel disruptions. Measures implemented in 2020 to limit the spread of the pandemic bear some similarities to the widespread travel disruptions in the aftermath of the terrorist attacks on the United States on September 11, 2001. U.S. airline passenger traffic fell by 30 percent in the immediate aftermath of the attacks, and remained as much as 7 percent lower after two years (Ito and Lee 2005).
The attacks also resulted in a sharp spike in uncertainty and prolonged the recession following the dot-com collapse in the United States, and hence the slowdown in global activity.
In the aftermath of the 9/11 attacks, oil prices fell sharply (by one-third over the following two months), while other commodity prices were largely unaffected.
Travel disruption disproportionately affected oil consumption but heightened uncertainty and slowing growth also weighed on oil demand. However, the oil price decline was short-lived: within six months, oil prices had returned above their pre-attack levels
Oil consumption growth averaged close to zero in the three quarters following the attacks, down from an average of 1.5 percent (y/y) in the previous four quarters.
Implications of oil price plunges for the global economy
Other things being equal, low oil prices might be expected to help boost global growth, including by stimulating energy-intensive activities such as travel and transportation.
Moreover, by dampening inflation, lower prices would also give central banks more room to ease monetary policy (Baffes et al. 2015; Ratti and Vespigniani 2016).
However, these effects would vary across countries: energy exporters in particular would suffer real income losses, which would dampen consumption and investment.
In practice, however, all of the oil price plunges since 1970 have been accompanied by global recessions, global slowdowns and, in some cases, widespread financial crises.
Three reasons may account for this. • Sources. Many of the past oil price plunges were themselves responses to economic downturns rather than independent shocks that might have triggered upturns (Cashin, Mohaddes, and Raissi 2014; Kilian 2009; Peersman and Van Robays 2012).
- Timing. During oil price plunges, the output losses in energy exporters materialized more quickly than output gains in energy importers, resulting in short-term global growth slowdowns (de Michelis, Ferreira, and Iacovelli, forthcoming).
- Asymmetries. Uncertainty, frictions, and asymmetric monetary policy responses can create asymmetries that increase the damage to energy exporters compared with the benefits to energy importers.
Past oil price plunges
Features of past plunges. Since 1970, the global economy has witnessed seven oil price plunges when oil prices fell by 30 percent or more over a six-month period: 1985-86, 1990-91, 1998, 2001, 2008-09, 2014-16, and 2020.
- Drivers. Oil price plunges in 1990-91, 1998, 2001, and 2008-09 were one-half (1998) to entirely (2008-09) demand-driven, whereas the oil price plunges of 1985-86 and 2014-16 were four-fifths and two-thirds supply-driven, respectively (Figure 4.2).10 • Persistence. Oil price plunges associated with global slowdowns were short-lived (1998, 2001), with oil prices regaining their preplunge levels in less than four years.
In contrast, oil price plunges around global recessions (1990-91, 2008-09) and largely supply-driven plunges (1985-86, 2014-16) were followed by more prolonged periods of low prices.
Conclusions
The restrictions imposed to stem the pandemic and the global recession triggered by the outbreak of the COVID-19 pandemic has been accompanied by an unprecedented collapse in oil demand and prices.
Unfortunately, the price decline is unlikely to provide much of an immediate buffer for global growth, because of the impact of mitigation measures that are constraining energy-intensive activities and because energy-exporting EMDEs have less fiscal and monetary policy room to counter the impact on their economies.
That said, there might be a short window early in a recovery when still-high inventories depress prices and support activity. Currently, responding to the health emergency and its impact on economic activity remains the immediate priority.
In both energy exporters and importers, support measures could focus on boosting health infrastructure and capacity, in addition to protecting employment and social safety nets.
To alleviate the burden on fiscal balance sheets, energy exporters and importers with high debt levels may want to preemptively identify priority expenditures that need to be safeguarded if financing shrinks, as well as lowerpriority, poorly targeted, or inefficient spending programs that can be delayed or suspended.
Additional liquidity could be injected in economies with low and stable inflation to enable banks to extend credit to firms and households, and to prevent widespread insolvency.
The economic damage of the pandemic could be long lasting, as it will take considerable time to repair the disruptions to labor markets, value chains, and balance sheets, and to restore consumers’ confidence in the safety of retail, leisure, and work spaces.
Culled from World Bank’s Global Economic Prospects, June 2020-07-18
