Negative Oil Prices? An Explainer
Oil is the most traded commodity in the world, with its total value traded easily exceeding that of gold and diamonds. For a nation, possessing vast quantities of this limited commodity quickly makes them a global player in the developed world. Better still, if they can set the prices, fairly or otherwise, their economic dominance is sure to follow. Japan, the US, and China all have lakes of oil at their disposal, mostly kept in strategic reserves in deep caverns or in purpose-built facilities dotted around their coastlines.
Even for this select group of countries that are nearly always buyers, the demand simply vanished and left traders on April 21st scrambling to sell, with the prices settling at a negative $37.63 per barrel. A historic moment for black gold. That said, what does this really mean in practical terms? Is it the end of civilization? Is the oil market crashing? Will Valve complete Half-Life 3? Well, no, but here are some interesting snippets to take away from this saga and I encourage you to share your insights if you see some missing below.
Data from MarketWatch.com, charting by self using Apex Charting JS.
Getting paid to buy oil?
At first glance, it does seem as though negative $37 per barrel is an absolute steal, as you are effectively being paid to take delivery of freshly extracted crude oil – but the story not so simple. Firstly, the barrel price in question is WTI, West Texas Intermediate, which represents a specific grade of “sweet” low-density oil that is sourced from the Texan Permian Basin. It is primarily traded on the New York Mercantile Exchange (NYMEX), in contracts of 1000 barrels (42,000 gallons). For WTI oil, the only way to take delivery is to use a pipeline or a truck. So, unlike Brent Crude from the North Sea, there are limited transportation and storage options. It also means hiring a truck and equipment to receive the oil from the extraction point. Making transportation a significant cost of WTI oil.
Secondly, the negative price per barrel was not for April, but for in fact May. This is because the contract to buy WTI oil was called a ‘futures contract’ or a piece a paper to you and I. Put simply, a futures market is one that is dated in the future for a specific quantity and price of oil to be traded at. This is available for many other commodities like corn, wheat, sugar, coffee, and more. The idea being is that large companies like airlines, cruise ships, and other energy-intensive industries can buy their fuel ahead of time to smoothen out any price volatilities while also helping them to calculate their forward operating costs. So, if Delta Airlines bought fuel on a day-to-day basis, then your flight ticket would change daily, not very practical. Using futures contracts is a necessity for many global businesses.
Lastly, transporting oil is a dangerous business, in its unrefined form, it is highly toxic as it releases vapors, requires constant monitoring to prevent fires and needs specialist equipment to store it. With all this in mind, the offer is looking a lot less attractive. A reporter from the New Zealand Herald once tried to buy a barrel and was told unequivocally, “don’t, it’ll kill you.”, no seriously, it will.
So to be succinct, the problems are:
- No one is using the oil as they are under lockdown, car drivers, businesses, etc.
- No company wants to buy oil, airlines, electric companies, etc.
- Existing storage is already near full capacity.
- May’s futures contracts were about to be executed and so the panic selling started as no one – especially speculators – did not want to take physical delivery.
Who exactly are the buyers?
So, who would buy a light and sweet crude, have access to trucks and pipelines, and is able to take delivery in May? Quite a specific set of parameters, but in fact, there are many buyers and some more speculative investors an hedge funds have already done so. Traditional buyers like refiners are not so keen on buying more products as demand has simply evaporated. With much of the world on lockdown, some 3 billion people, the need to use energy simply is not there. This has caused a backlog of existing products and a shortage of places to store it all. Hedge funds looking to make a quick return on the situation have resorted to hiring large oil tankers to fill their holds and wait for then oil demand returns to normal. The only issue here is that there are a limited number of tankers and aging oil wells are expensive to halt. This has led to some tanker rental costs to increase by 700% as more are hoarding the black gold until the world economy recovers.
This ultimately means that speculators, without any oil infrastructure of their own, had to figure out what to do with the ‘contracts’ they had bought and find a way to take delivery. Given that many do not own or have access to the right equipment meant that there was a selling frenzy leading to contracts having a negative price. Also, many contracts cannot be carried over to the following month, so all contracts need to be ‘settled’ in some fashion prior to the final rollover date.
Can retail investors buy the oil?
You can, but to be realistic, it is best not to. While the NYMEX is the central place to buy WTI crude, and many have, the danger lies in when the contracts ‘roll over’ to the next month. If for whatever reason, you are unable to cancel or sell your futures contract, then you will get a swift and polite call from the exchange asking where to send the oil you had bought. If you happen to be the purchasing manager for a billion-dollar oil company or refinery, then you can direct them to one of your several collection facilities dotted around the country.
If you are still game to buy some difficult to store and definitely toxic crude oil, then you can call an oil company like Glencore, Vitol, and others to have them sell you a bit of their oil. Again, the request to buy crude oil in small volumes will be considered strange, and perhaps even an annoyance, but those who persist will be able to do so – given time.
The trading of oil is complex is not for the faint of heart. If you absolutely want to invest then it would be advisable to buy shares in a company related to oil in some fashion, it might be the building of equipment, maintenance, extraction, refining, or destruction. Remember, I am not a financial advisor, and this is not a recommendation to buy anything. Your risks are your own responsibility. Case in point, a user on Reddit posted a story of their loss on buying an oil EFT on Friday. Commodity markets can swing in either direction very quickly, like the natural gas market not too long ago, and can cause life-changing consequences.
Extract less oil
Any sensible person would want to close off the pipes or shut down the wells, at least for the short term. Cutting back on supply is not as simple as turning off a tap like you would at a sink in your kitchen. For starters, many wells are of different ages, so that means younger wells are able to spurt out great quantities of oil without assistance thanks to a build-up of natural gas. Finding a way to cap that pressure can be done but it would take a few days or even weeks. Older wells, however, they need to be assisted in some way when the gas pressure underground falls too low. This is a long-term engineering solution that has never really needed to be turned off, as the assumption has always been that oil will be needed. Even if it could be turned off, the process of ‘offlining’ a well would cost a small fortune and is probably equal to that of storage for the duration of it being offline.
Since this is an unprecedented event no one quite knows what to do or what the best path to equilibrium will be.
The end of US oil independence?
The oil glut will lead to wider economic and industry problems for the foreseeable future – with some political intervention needed. The US, since 2015, has invested heavily in developing its own oil fields to become energy independent and thus relying less on imports, namely from the Middle East. As with most oil and gas investments, the cost of equipment is benchmarked on an assumption that oil will never be less than a certain amount of US dollars. For Saudi Arabia and their fields, it is known that an oil price of about $9 per barrel is profitable – just – as their cost of production is approximately $8.98. Ideally, more than $9 is desired. For the US, however, the production cost is $20.99, so the oil price will need to be higher than this amount to become a viable investment and have a healthy return on said investment.
With the oil price collapsing as it is and Russia and Saudia Arabia pumping more oil than before, the stage is set for a reckoning for the US oil industry. There is a chance that the US would be oversupplied by imports and thus lowers the incentive, profitability, and viability of utilising their onshore oil reserves. When faced with large established producers the US oil industry will not be able to produce a convincing rebuttal as much of the innovation has been in terms of oil extraction technology and so, there would be a time lag to respond. Not only that, Saudia Arabia’s ability to cheaply extract oil will only be stopped through political intervention. A policy that has not ever happened before. So it may appear the US oil industry is at a crossroads where its survival is at stake.
Balancing the books
Many countries and governments around the world rely heavily on the sale of oil to balance their books. Russia, for instance, depends on more than half of its GDP to be generated from petroleum products. In a world where global oil prices are lowering due to reduced demand, this could cause suffering for the people of these nations as reduced revenues will impact government spending and the overall economy. With the WHO predicting oncoming famines around the world, there is potential for further catastrophes with reduced sovereign incomes to mitigate this disaster.
A look ahead
The oil market is set for more instability with multiple factors of global instability, political grandstanding, and reduced demand forming a long-term trend of unpredictability. That said, this may not be the first, last, and only time that prices might travel below zero, as the world is traversing low demand but also a transition into terra incognita.