How the mighty are fallen

Khalid Umar Rajoka analyses the economic impact of unwanted oil, once the world’s most sought after commodity

How the mighty are fallen

A fruit vendor will pay you hundred rupees if you take away a dozen apples from his pushcart. Does this sound real? Yes it does, because this is what happened last month with crude oil, once the world’s most sought-after commodity, when the USA benchmark of crude oil prices - Western Texas Intermediate (WTI) future contracts - were selling close to a negative US$40 a barrel. That means oil producers were willing to pay nearly US$40 a barrel to take away oil from their production facilities.

This is a lifetime’s opportunity for a student of economics to witness the phenomenon of negative prices. So what caused such an inglorious fall in crude oil prices? Generally, crude oil prices are determined by three factors – global economic growth, political certainty or the lack of it, and supply boom. Although the Straits of Hormuz – the single most important passageway for global oil supply – continue to remain tense, global economic growth and supply excess appear to have determined this historic fall in crude oil prices.

The COVID-19 pandemic in the last month of 2019 brought economic activity to a grinding halt in China, the world’s second largest economy. In the first quarter of 2020, gross domestic product (GDP) of China shrank by 6.8%, its lowest contraction in nearly three decades. As COVID-19 began to globalize, strict lockdowns ensued, practically bringing the global economic engine to a screeching halt and evaporating demand on an unprecedented scale. On the supply side, the collapse of the supply stability pact between Organization of Petroleum Exporting Countries (OPEC) and Russia opened the tap, and reckless oil production began, regardless of demand. This resulted in a price war between Russia and Saudi Arabia, the world’s largest oil producers. Together, the pandemic and  oversupply have plunged oil prices to unprecedented lows. With no demand and no breaks on production, onshore and offshore storage facilities were overwhelmed. Oil speculators and traders panicked; this started a spree to dispose of future contracts.

If oil continues its downward trajectory for a longer period, there is a likelihood that gains may be offset by countervailing factors

In order to stabilize oil prices US President Trump had to intervene and not only did he broker a deal between OPEC and Russia to cut oil production by 10%, he also offered strategic storage facilities to accommodate oversupply. Despite Trump’s interventions, it is too early to predict the future of oil prices. Oil watchers are divided over prospects of a short-term rebound and continued slide of oil prices in the long run. The future of oil hinges on the abatement of the pandemic and resumption of economic activity.

These historic low oil prices have generated optimism in Pakistan, a country that burns out billions of dollars on imported oil to grease its economic machine. Is our optimism unfounded or real?

Undoubtedly, contraction in domestic demand due to lockdowns and low oil prices will ease pressure on the external account and save precious dollar reserves. However, if oil continues its downward trajectory for a longer period, there is a likelihood that gains may be offset by countervailing factors.

First, shutting down of vital sectors of the economy (manufacturing, transport, construction, services etc) means less collection of taxes and levies imposed on the sale of petroleum products, hurting the government’s revenue targets. Stopped early last month, the government has allowed the resumption of crude oil import as economic activity picks up with reopening.

Second, remittances (the bedrock of Pakistan’s dollar reserves) continue to cushion the economy against patchy inflows of investment and stagnant export earnings. The pandemic has exposed the vulnerability of this stable source of dollar reserves. A majority of over ten million overseas Pakistanis work in Gulf Cooperation Council (GCC) countries which are major oil producers and the source of bulk of remittances for Pakistan. A free fall in oil prices will adversely affect remittances. The fear is that if the recession continues to bite, layoffs and retrenchment of workers will exert additional pressure on the government to bring them back. According to the World Bank Daily Quartz Brief, a 20 percent reduction in global remittance flows is expected in the current year. This implies about a reduction of US$ 4-5 billion in remittance inflow for Pakistan. Moreover, the US and UK are other major contributors to Pakistan’s remittances earnings. Prolonged recession in these countries will exert further pressure on the flow of dollar earnings.

Third, when the pandemic forced the shutting down of factories in China, pundits were upbeat about Pakistan seizing the opportunity and filling the supply gap, especially in the textile sector. They were partially right as at some point the textile sector was operating at full capacity. But then the most equalizing factor – the covid-19 – began to hit export destinations in the EU (Pakistan enjoys GSP plus status in EU markets) and the US forcing exporters to put shipments on the hold. As the specter of prolonged recession deepens, it is quite unlikely that exports will gain steam at least in 2020, depriving the country of much-needed dollar earnings in the interim period. However, amid all the gloom a small uptick in exports to Africa is recorded.

Four, global economic inactivity foreshadows an ominous recession, yawning fiscal deficits, mounting debts and historic levels of unemployment the investors the world over will mine the safest assets to park their excess cash. The guestimate is that investors will park their money in the greenback and gold to hedge against any future slump in global currencies. This is certainly not a good sign for Pakistan where foreign investment has a checkered record. March witnessed an outflow of US$2 billion from portfolio investment. It is improbable that in the current situation Pakistan will be able to attract foreign investment. The attractiveness of Pakistan’s market for short-term, portfolio investment was further eroded with a substantial reduction in interest rates and there are chances of further drops as demand evaporates and inflation remains under control. Sadly, as oil remains cheap the economic incentive to invest in green technologies plummets, further dampening prospects of foreign investment in renewable energy.

Finally, consumer confidence is arguably the most important factor in determining the interplay between demand and supply. Consumer confidence is shaken like never before, with unending lockdowns, economic inactivity, fear of contracting the virus and alarming delays in the production of the Coronavirus vaccine. This might usher in a new era of substantially reduced consumer spending exacerbating the economic recession.

The writer is a Fulbright Scholar and a civil servant, currently deputed to Central Asia Regional Economic Cooperation (CAREC) Institute, China. He can be reached at (Twitter: @khalidrajoka79)