Pain Paid at the Pump?

The sharp decline in oil prices took on a new dimension when, for the first time in history, NYMEX WTI Crude contracts traded with a negative price. How that happened, the implications of it, and whether it will happen again are a matter for discussion.

The negative move in oil does not have as much to do with an international price war as it does with a lack of demand exacerbated by the full storage capacity in the United States and the financial mechanics of the market. 

Global oil demand has been trending towards 100 million barrels per day, but the International Energy Agency expects global oil demand to suffer it’s largest year over year decline ever – a drop of 29 million barrels per day in April. This puts global oil consumption at the lowest level since 1995. A recovery isn’t expected anytime soon. Looking out to December, the IEA still expects demand to be 2.7 million barrels per day below where it was in 2019. In that context, the OPEC+ agreement between Russia and Saudi Arabia to cut production by nearly 10 million barrels per day suddenly seems less dramatic.

This decline in demand has caused a glut of oil, which has been forced into storage facilities instead of into consumers’ (individual, transportation, aviation, and industrial users’) tanks. In it’s Weekly Petroleum Status Report, the Energy Information Administration (EIA) reports that storage levels are at record levels of the five year range, and Bloomberg has reported that Goldman Sachs estimates we will be at full capacity within 3-4 weeks.

This lack of storage has a significant impact on the price of crude oil and the quoted price of NYMEX WTI Crude, the product most often referenced in the United States.  Crude oil is traded in standardized, monthly contracts on the futures market, and buyers of the contract are obliged to take physical delivery of the oil. When buyers had no ability to take possession and store the oil they had previously purchased (for example, investment funds that had no intention of taking possession of the oil and intended to sell those contracts at a profit to an end-user), they were forced to pay others to take delivery, reflected in the negative price.

Until US demand rebounds, storage availability increases, and investors have unwound themselves from contracts obliging delivery while there is no demand, there remains significant downward pressure on oil prices that even an unexpected global supply cut would be unlikely to resolve. All eyes are on May 19, the last day of trading for the June crude contracts, to see if we hit negative prices again.

The May West Texas Intermediate oil contracts went negative because they mandated physical delivery of the oil, and oil storage facilities were at risk of overflowing due to low demand and the oil price war between Saudi Arabia and Russia. Because the costs of shutting off wells and pipelines are so high, oil companies briefly paid people to take these contracts which is completely unprecedented. The whole system was not set up for a black swan event such as coronavirus. Almost all financial modeling had not accounted for a stochastic shock of this magnitude. 

There are some interesting geopolitical elements at play here. It seems China (the world’s top oil importer) is benefiting greatly off of cheaper oil by filling its strategic reserves, but at the same time its state-owned oil companies may struggle. 

Before this crisis, OPECs power had become greatly diminished due to developments in the US shale market. This price war threatens to destroy US shale, and give pricing control almost exclusively back to OPEC nations.

However, economic theory about cartels suggests that they are fragile, and a race to the bottom (like this current price war) may threaten to destroy any cohesion of the cartel when it comes to agreement on pricing.

Saudi Arabia tried to destroy US shale in 2016. It did not work out well.