oil and gas in the sea

South Africa: Oil prices drop: What will fuel the energy industry
post-COVID-19?

Publication May 2020


Introduction

On April 20, 2020, the global petroleum industry witnessed a historic plummeting of benchmark US oil below $0 a barrel, while Brent crude oil has fallen nearly 70 per cent from the beginning of the year. The drop in oil prices raises questions about the future of the global and regional energy industry as well as the role of fossil fuels in the transition towards a more sustainable energy future after the pandemic economic lockdown.

What happened?

The West Texas Intermediate (“WTI”) contract serves as the benchmark for crude oil prices in the US while Brent crude oil remains the international oil price benchmark. The plummeting of the WTI oil price was the direct consequence of an oversupply of fuel and a declining demand for fuel amidst travel restrictions and economic lockdowns. Many economies have severely shut down to prevent the spread of the COVID-19 virus, which in turn wiped out the demand for oil as transport almost came to a halt. According to the US Energy Information Administration (“EIA”) report, road transport in countries under lockdowns dropped 50 percent below 2019 activity, while air transport declined more than 90 percent. As a result, the oil demand plummeted by 10.8 million barrels per day  year-on-year, pushing the Q1 demand in advanced economies down by 2.3 million barrels per day by 3.3 million barrels per day for the rest of the world.

While the global oil sector has already witnessed declining oil prices because of a price war between Saudi Arabia and Russia, the rise of COVID-19 will certainly exacerbate existing price declines. Amidst all this, OPEC failed to reach an effective agreement on the cut of oil production. 

All of the above factors combined have resulted in a steep decline in oil prices. 

The oversupply of fuel has resulted in a lack of storage facilities because of over-capacity fuel tanks. As a result, traders are looking to store the oil in anticipation that the oil price will recover. As land-based storage is mostly full, traders are looking at very large offshore floating storage facilities and rail tanker cars, which come with practical and legal issues of their own.

Contracts and full storage tanks

The lack of storage capacity because of the demand/supply mismatch has seen traders seeking relief in the form of force majeure or hardship provisions in their contracts to avoid or delay taking delivery of more fuel. The purpose of force majeure provisions in contracts is to relax contractual obligations for a period or permanently, when an event occurs which was out of the parties’ control, and which prevents performance. In South Africa, the common law principle of supervening impossibility can be applied , but it will only be applied where performance is absolutely or objectively impossible. Where storage tanks are full, traders may be able to offload to another storage facility if delivery cannot be taken of oil. 

While it could be argued that over-capacity fuel tanks may not necessarily constitute force majeure, it could be construed as a contractual hardship. Many traders include hardship provisions in their contracts, which result in a renegotiation of terms in the event of an unforeseeable event that economically disadvantages a party to a contract and makes performance burdensome. We have seen companies prefer to renegotiate contracts over enforcing force majeure clauses. However, the longer the situation persists, more companies may rely on force majeure.

Impact on Sub-Sahara Africa

While the WTI fuel price relates to US oil industry, the general decline in the oil price and increasing lack of storage capacity has ripple effects on the global oil industry and specifically in sub-Saharan Africa. This is because oil producing countries depend on higher oil prices for the functioning of their economies. 

Nigeria serves as Africa’s biggest oil producer. According to the International Monetary Fund (IMF), 60 per cent of the country’s foreign revenue and 90 per cent of its foreign exchange is dependent on oil sales. Oil revenue currently comprises 9 per cent of Nigeria’s GDP. The IMF suggests that because of the decline in oil prices, oil revenue will drop by 3.4 per cent, which will have a severe impact on their economy.

Angola, the second largest producer of oil in Africa, produces an estimated 1.9 million barrels a day. According to the World Bank, oil production in Angola accounted for a third of its GDP and 90 per cent of the country’s exports in 2018. Equally, it is expected that the lower oil price will have a severe impact on this country’s economy 

The economies of emerging oil countries like Ghana, Kenya and Uganda, will also be negatively affected.

In countries where exploration is underway, oil and gas companies will weigh up their risks to establish whether to continue, delay or withdraw investment.

Impact on the oil industry

Many oil producers are hesitant to drastically reduce oil production. This is because it is very costly to ramp up production again. It is possible that the oil price crash will cut out the smaller oil producers, who are more vulnerable. We have already seen that some small- to mid-size oil companies have lost more than two-thirds of their value. This could result in the centralisation of production in the hands of oil majors. However, oil majors have already announced that they are cutting their capital expenditure, some by as much as 30 per cent. Oil companies play a very big role in the US economy and the American government has announced that it will make funds available to these companies to assist in the midst of the pandemic.

The consumer’s pocket

The decreasing demand for fuel can also be seen at the petrol station pump, where restrictions on movement globally have significantly affected the demand for fuel. In America, the price of a gallon of gas is US$1.80 cheaper than it was in 2019. In Nigeria, the fuel price was cut by 20 Naira in March 2020 to mitigate the economic impact of the COVID-19 pandemic.

In South Africa, the Saudi-Russia price war resulted in a fuel price cut of R2 per litre in April 2020. Storage capability, price, levies, taxes and the exchange rate will however continue to play an important role in determining the fuel price in South Africa. Extra tax levies might be introduced to make up the losses government suffers as a result of the pandemic.

Post the pandemic

It is uncertain what life will look like in the oil industry post COVID-19. Even if the demand for oil returns to its normal state, it will take a while to consume the oversupply, since approximately 30 million barrels a day have been pumped into storage over the last three months. 

The drop in oil prices raises questions about the future of the global and regional energy industry as well as the role of fossil fuels in the transition towards a more sustainable energy future after the pandemic. The global economy is already undergoing an energy transition from fossil fuels to more sustainable energy sources. Renewables are increasingly deflationary, and oil prices will have to compete with this, notwithstanding the economic- and pandemic-driven oil price drop. For example, in April 2020, Solar PV tariffs were recorded in Abu Dhabi at US$1.35 cents per kWh.  Furthermore, China, the world’s largest importer of oil, has announced a three-year plan increase on the production of electric vehicles in their country. This plan has been endorsed by 24 provinces in China. It is clear that economies who are oil import-dependent are already developing policies to diversify their energy mix in order to ensure energy security and become less reliant on oil imports. 

The goal of the United Nations Sustainable Development to ensure access to “affordable, reliable, sustainable and modern energy for all” will largely rely on the decisions of policymakers, company strategies and price.  

It is possible that we will see a further diversification in the energy market and that renewable energy may play a bigger part. However, it is important that energy resources be balanced in sustainable and equitable manner that will support the growth of the world’s economy.



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