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Effect of drastic fall in oil prices – Is the drop in oil prices good for Kenya?

As the effects of the Covid-19 pandemic weaken global demand, oil markets are facing an unprecedented crisis. The US’s benchmark index for WTI crude oil dropped below $0 on April 20th following the sharp decline in its demand outlook. Coming closer home, we ask, will falling global oil prices help Kenyans?

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It has been a season of immense economic shocks in the global economy. The Russia–Saudi Arabia oil price war, Brexit, climate change, and locust invasion in some parts of East Africa and South Asia,  and now the COVID-19 pandemic. The drastic drop in oil prices might have come at the right time to salvage oil-importing economies but extending the nightmare to exporters.

The price of West Texas Intermediate (WTI) oil per barrel plummeted for the first time in history beyond zero, closing at -$37 per barrel on April 20th and -$16.74 the following day.  Essentially, the cost of refining and storage of oil is higher than the cost of buying the oil. This dip created a unique situation where suppliers would need to pay consumers to clear their dead stock. This is not rational or feasible since there is no trader willing to accept physical oil stock at the moment due to low demand.

Figure: A sharp decline in oil prices below $ 0 per barrel on April 20th closing at $-37.63.

Source of Data: Business Insider

Covid-19 has caused disequilibrium in the demand and supply of oil following interference and slowdown of key economic activities. Closure of businesses, loss of jobs, reduced government spending in some sectors, reduced income earnings, lockdown, and curfews have adversely affected the demand for oil in the market while supply is unaffected. Oil-producing countries are currently running out of space to store crude oil with global oil statistics showing a 30 percent decline in daily demand of nearly 30 million barrels per day.

Effects

The sharp drop in oil prices is bad news to the balance of payments for oil exporters like Russia, Venezuela, and Nigeria but ‘good news’ to the oil importers. However, with the restrictions and measures taken against COVID-19, it is not good news as such. For oil importers,  demand is low following the travel restrictions and movements. The effects of the price war on the supply side are colliding against the all-time low demand destruction following the havoc caused by the Covid-19 pandemic.

Further, it is expected that there will be a crowding-out effect of ‘small investors’ in the oil trade who cannot sustain oil extraction due to the prevailing prices. The small companies will shelf or reduce the delivery of WTI by May. Further reports have shown that traders have liquidated their positions by trading their contracts at very low prices.

On the other hand, bad debts will increase further due to the lump sum money invested by traders and banks in the oil extraction business which turns into non-performing loans. Bad debts in Kenya have been increasing since 2015 from 5.6 percent (non-performing loans to gross loans) to an average of 12 percent in 2019 due to the accumulation of payment arrears by the government and financial problems affecting a cross-section of corporates.

The low price could affect the progress of renewable energy by competing with biofuels to displace gasoline in transportation, by making vehicles powered by internal combustion engines more competitive with electric vehicles, and by potentially reducing natural gas prices. Lower fuel prices will also reduce consumer incentives to purchase electric vehicles. Additionally, oil-exporting countries will possibly cut down on their spending especially on subsidies like an investment in renewable energy. 

The COVID-19 pandemic induced economic shock may lead to a recession by the end of 2020 that is not associated with poor monetary or fiscal policies, but associated with insufficient economic stimulus directed towards specific sectors to spur economic growth. If the global lockdown and national measures continue for a few more months, global oil producers could be left in a heap of trouble.

Will Kenya Benefit?

Not very soon. Kenyans will have to wait until May 14th for the Energy & Petroleum Authority (EPRA) to announce the maximum retail pump price in accordance with Section 101(y) of the Petroleum Act 2019, Legal Notice No.196 of 2010 and Legal Notice No. 26 of 2012. 

The calculation for the current oil prices was based on the average price of Murban crude oil imported in March 2020 at the cost of US$35.58 per barrel according to EPRA. This was a drop by 36.58% from $ 56.10 per barrel in February 2020 in part due to a $2.75 discount per barrel offered by Abu Dhabi National Oil Company (ADNOC). 

ADNOC has announced a further discount for May’s official selling price of $6.95 per barrel for its Murban crude. This means a further 60% reduction in fuel prices in Kenya taking into account inflation in May.

The effects of movement restrictions among other measures taken by the government to combat Covid-19 will supersede the effects of the decline in the oil price since some benefits associated with lower oil prices like transport and cheap airline tickets will not be felt because of the movement restrictions. The demand for oil will still be low. However, in circumstances where the demand may rise if government restrictions are lifted, then Kenyans will be able to save some cash since they will have to pay relatively higher following the appreciation of US $ against the Kenyan shilling from 101.1 in February to 107.25 in April. 

The drop in oil prices will not benefit consumers in the short run since the actual selling price of diesel, paraffin, and petrol in Kenya is unlikely to drop as much as the decline in crude oil prices because of the tax levies, cost of refining and transport cost. Forty percent of the price of oil for consumers is actually made up of government taxes.

The transportation sector – which contributes to 15% of GDP in the country – will not benefit much either since road transport – which accounts for over 80% of the internal freight which has been affected by movement restrictions especially in and out of major cities and towns in the country.

Benefits from the fall in oil prices

About 1.7 million (14% of the total population) households in Kenya using kerosene for cooking and lighting and seven percent of the total population using liquid petroleum gas (LPG) for cooking will benefit from the price drop from May as gas prices at the pump reduce and the price of kerosene declines. The drop in fuel price will directly reduce the cost of petroleum-based products and manufactured goods. 

Furthermore, the reduction in oil prices and heavy rains experienced currently in the country will reduce the cost of energy production. The cost of electricity will be cheaper since more power will be generated from hydropower plants in Kenya, and as a result reducing the use of thermal energy.

The decline in the price of fuel could have come at the right time for farmers since this is the planting season, and agriculture has been boosted by the timely rains experienced across the country. The cost of running agricultural machinery such as tractors will reduce directly. However, since farmers are price-takers the extent of the drop in fuel prices will not proportionally translate to the cost of production. 

With these in mind, EGCL recommends the following:

  1. As most economic activities will be affected by the drop in oil price, inflation will likely reduce. This will encourage people to borrow and spend. The government can capitalize on this by halting some fiscal measures like the reduced Central Bank Rate and Cash Reserve Ratio which were imposed earlier since the economy will be stimulated by low fuel prices and low inflation.
  2. The government should consider reducing tax levies on fuel including the Railway Development Levy and anti-adulteration levy. This will help reduce higher retail margins between the wholesalers of fuel products and petrol station owners. It will also ensure all the benefits of the lower oil prices are transferred to the end consumers.
  3. The possible lower inflation which cannot be offset by lower interest rates could be dangerous to Kenya’s economy. EGCL recommends the use of forward guidance to influence financial decisions of households, businesses, and investors to anchor medium-run inflation expectations and avoid sustained deflation which contributes to lower economic growth.

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