I wrote recently about the increasing incidences of negative electricity prices, driven by the limited ability to store electricity meaning that to all intents and purposes, electricity is consumed as it is generated. However, electricity is not the only market where prices can turn negative and buyers are paid to purchase a product.
Front-month WTI turned negative for the first time in history
Yesterday, for the first time in history, the crude oil benchmark, West Texas Intermediate (“WTI”) turned negative. The reasons for this are quite technical – the US oil market is a pipeline market with the WTI contracts being valued for delivery at Cushing in Oklahoma, an area where the storage facilities are somewhat limited and largely full.
As heavy industry has been shuttered as a result of Covid-19, use of oil across the value chain has fallen dramatically in a very short period of time. This has meant that in places where there is little available storage capacity or user demand, the prospect of receiving new quantities of oil becomes hugely problematic, and this is exactly what happens with futures contracts when they come to delivery. Each WTI contract, traded on the CME Group’s New York Mercantile Exchange, is physically delivered in the amount of 1,000 barrels.
The WTI benchmark that has turned negative is the front month contract which expires today, so holders of the contracts have been desperate to offload them to avoid taking delivery of oil which will be difficult to use and very expensive to store, leading them to pay people to take this oil off their hands.
May 2020 WTI fell from US$17.76 /bbl on Friday, to a low of -US$37.63 yesterday, before recovering to US$10.01 /bbl today, the final day of trading for the contract.
“With adequate storage in Cushing unavailable to those who need it, selling intensified. This issue is most intense for May WTI because oil demand is at its weakest, with full coronavirus containment measures in place across much of the US. Storage at the Oklahoma facility is expected to be full within weeks,”
– Ann-Louise Hittle, Wood Mackenzie
On 10 April the storage facilities at Cushing held 55 million barrels of crude, which is around 72% of the working storage capacity of 76.1 million barrels, according to the Energy Information Administration. However this reflects the physical oil in store and not the amount of capacity that was leased out, meaning the remaining capacity is not necessarily available to owners of the front-month WTI contract as capacity holders held out for the highest prices.
WTI contracts for delivery over the next few months have also seen their prices fall, but are still firmly positive, since the near-term over-supply issues have yet to hit them – and may not, as production is adjusted and stocks are slowly consumed. In addition, the US government is considering making use of its Strategic Petroleum Reserve (“SPR”) as temporary storage – President Trump has spoken about putting as much as 75 million barrels into the SPR, filling its capacity, and deploying financial incentives to encourage producers to cut output.
Brent crude, the measure of oil pricing based on the Brent Blend, Forties Blend, Oseberg and Ekofisk crudes produced in the North Sea, is not subject to the same storage pressures since Brent is a sea-borne market – the oil is shipped by tanker (typically Very Large Crude Carriers or VLCCs, which can hold around 2 million barrels equivalent) and transported to oil-consuming markets around the world. Although the storage capacity of these tankers is also largely full, there is still spare capacity in large oil importing nations such as South Korea, Japan, India and China, meaning the pressure on the Brent contracts is significantly lower.
What does this mean for oil prices over the coming months?
Two weeks ago, OPEC and others including the US, Canada, Russia and Brazil agreed to cut oil production in order to prevent a collapse in prices due to global over-supply, after a brief “oil war” which saw Saudi Arabia, the world’s swing producer increase output as demand fell due to the Covid-19 crisis.
This is a tactic periodically followed by the Saudis as it tries to price out the competition. Saudi Arabia is the world’s lowest-cost producer with a production break-even of US$20 /bbl versus US$40 /bbl in Russia. Both countries rely heavily on oil to support their economies, with oil funding 87% of Saudi Arabia’s national budget, and 68% of Russia’s. For these countries to balance their books they need to see oil prices of around US$80 /bbl and US$60 /bbl respectively.
The “OPEC+” agreement to cut production will reduce global supply by 9.7 million barrels per day, which amounts to around a third of the global daily oversupply. The question is whether this will be enough to support prices as most countries in outside Asia remain in lockdown.
“It hasn’t taken long for the market to recognise that the Opec+ deal will not, in its present form, be enough to balance oil markets,”
-Stephen Innes, chief global market strategist, Axicorp
The collapse of the WTI front month contract has garnered headlines round the world, and is something of an embarrassment for the Opec+ countries who expected their production cuts to halt the drop in prices, but to a certain extent this is unfair: the term “demand destruction “ is often used to signify falling demand, but never before has it described literal elimination of demand on such a scale.
Analysts expect production will need to be cut further to bring the markets back into balance, however in the near term even that may not be enough. The International Energy Agency (“IEA”) expects US producers will be forced to reduce production significantly and predicts output will be 2 million barrels per day lower by the end of the year than in December 2019.
“There is no feasible agreement that could cut supply by enough to offset such near-term demand losses,”
– International Energy Agency
The IEA has suggested that a gradual recovery may begin to gain some traction in June as recovering demand makes some inroads into storage balances. But at this point any sort of price recovery looks unlikely for some time.
In the short term, traders holding WTI contracts whose value collapsed from +US$20 /bbl to -US$40 /bbl will have taken major losses, although those that managed to hang on towards the contract’s expiry would have benefitted from its recovery to around US$10 /bbl. But, as pointed out in the FT, one day’s losses will not decimate the US energy sector.
However, the bigger issue is the extent to which supply continues to exceed demand during the lockdown. The US is now producing 2 million barrels of oil per day more than its refineries require, so unless new storage capacity is found, some of that excess production will need to be shut in. The markets are showing some concerns on this point – the June contract, which rolls into the front month tomorrow, has lost almost half its value since Friday, and even Brent dipped below US$18.00 /bbl during today’s trading, before recovering to close at US$19.86/bbl.
“The biggest impact will be bankruptcies. Despite many oil companies cutting capital expenditure by up to 50%, many, many companies are going to go bankrupt. Around 80 oil and gas companies filed for bankruptcy in the 2015 sell-off. The current situation is far worse than 2015, so the industry is going to look very different after this wash out. These bankruptcies will not be limited to the US, but will also likely occur in Asia, Latin America and Europe,”
– Mark Lacey, Head of Commodities at Schroders
The breakeven price for US oil production is in the range of US$48 – US$54 /bbl, so any sustained period of lower prices will inevitably put some producers out of business. Painful as that might be, the US has a diverse economy (oil accounted for just 8% of GDP in 2018) and will weather the storm.
The real difficulties will be felt in countries which rely on oil revenues to support not only their economies but their entire political structures, as is the case in Russia and Saudi Arabia. The economic and political implications of Covid-19 are only just emerging – the exent of the harm will depend on how quickly lock-downs are lifted and demand can begin to recover.