The Crude Oil Reckoning
By Sam Triantafillopoulos and Henry Yu
What on earth is going on with the oil prices? Well, it’s a question that seasoned commodities traders have been asking themselves too. The oil price has been under pressure for a long time. However, the past days have brought unprecedented volatility due to the recent COVID-19 outbreak. The collapse in global economic activity means that the world simply does not need that much oil at the moment, yet the producers are still pumping. This demand and supply issue has caused oil to be traded in negative territory for the first time in history.
Demand and supply
Ever since 2017, global oil demand has been declining from around 95 million barrels per day to roughly 88. This downward trend is not going to reverse with the current pandemic. As early as mid-January, the future of oil demand came into question as the coronavirus spread, prompting factory closures and trip cancellations in China. These concerns have now intensified – many countries have gone into lockdowns and air travel has largely been halted in a bid to precent infections.
According to Energy Information Administration of America, consumption of motor oil in the US is down 50% in the month of April, as well as airline fuel. Americans used to spend 10 million gallons of fuel on their cars each and every day, now it is down to about only 5 million gallons a day. In fact, American demand for gasoline has not been this low since 1969 when the population was 40% lower and much fewer people had cars.
On the supply side, prior to the oil future price plummeted on Tuesday, our two largest oil producers – Saudi Arabia and Russia – were set to increase production dramatically in April, after an agreement between OPEC and its allies to lower output expired at the end of March. Saudi Aramco, state-owned oil company in Saudi Arabia, said in a statement last month that it will provide 12.3 million barrels per day of crude oil in April. That is nearly 2 million bpd (barrels per day) more than an estimate for March, according to Refinitive Eikon data.
Russia’s Energy Minister Alexander Novak said his country can also increase its production by 500,000 bpd in longer term. This ongoing production battle between Saudi and Russia is to compete for global market share.
With shrinking demand and high production of oil, storage capacity is filling up fast. There are about 3.2 billion barrels of crude oil already in global inventories, according to Orbital Insight, a record high.
Therefore, with oil storage capacity quickly running out, this creates excessive downward pressure, with West Texas Intermediate, the US oil benchmark, trading as low as -$40.32 a barrel during a chaotic trading session on Monday when it registered its largest ever one-day fall. Negative prices meant that some producers were actually paying buyers to take oil off their hands.
The concept of futures
Does negative oil price in futures markets imply that you can go to your gas station and get paid to fill up your tank? No. These prices are based on trading of oil futures and expiring contracts. These are just market mechanics with the May futures contract of WTI expiring on Tuesday, which means holders of oil contracts will need to find a place to physically store the amount of oil they have purchased by then. Basically, the US is running out places to store its oil. As a result, the price of contract is going negative as people think that there is not going to be any more storage capacity. Keep in mind, this is only for a very short term – for May, the price from oil that is set to be delivered in June is still trading around $20 a barrel. It is definitely a lot lower than before but is not as bad as negative 40 dollars.
Extractors face mounting pressure
With spot oil trading at around $20 a barrel and futures occasionally pricing below $0, the structure of the oil market has changed entirely. The operating models of many existing extractors in the United States were engineered in a period in which stubbornly high prices were driving refiners to search domestically for crude oil. Chief among these is the Bakken formation, a massive rock unit concentrated in North Dakota and Montana.
Oil extraction here involves the breaking up of rock and the use of water pressure to dislodge crude oil hidden far deeper in the earth than conventional reserves in Venezuela, Saudi Arabia, and the offshore formations in Texas and California. This is of paramount importance for extractors as the capital expenditure involved is typically prohibitive at sub-$50 oil prices.
The worst among us…
While some exploration companies, thanks to the ever-plunging cost of debt, managed continue operations as the oil glut accelerated in 2014 and 2015, the COVID-19 pandemic has significantly impacted the solvency of these firms. The first canary to cease its song was Whiting Petroleum, a Colorado based exploration and extraction firm with more that 80% exposure to the Bakken formation.
Whiting petroleum posted negative free cash flows in excess of $300 million for the year ended 31 December 2019, and had failed to produce positive free cash flows for the last 3 calendar years. For every dollar earned in pre-tax profit, the firm paid $62 in capital expenditures, with depreciation costs comprising a staggering 52% of revenue. Whiting Petroleum filed for Chapter 11 bankruptcy in early April, with analysts seeing the company as an extreme example of the high debt load endemic to the industry rather than an outlier.
Oil as a deflationary indicator
Oil prices typically move in step with inflation, providing some indication of the health of the world economy on a nominal basis. Growing consumption, money velocity and fertility rates all tend to reflect higher oil prices, which typically indicate a higher premium on economic activity. Periods of secular stagnation likewise reflect lower energy costs, and the last time this occurred was in 2015 and 2016, wherein an industrial recession in the United States lagged a reduction in oil prices on an approximate 10-month basis.
Falling inflation is key because as this occurs rates tend to fall, which is exactly why many extractors remained in business even as oil prices fell; lower oil revenues were offset by falling financing costs. The result? Increasingly unprofitable firms saddled with even greater debt loads. This time around, the effects are much more acute, and the results are more final.
Not only have rock bottom oil prices punched a hole in already softer profit margins for American oil companies, but the outright shutdown of the economy has meant many firms are not solvent, that is, able to meet financial obligations on a short-term basis.
The beginning of a seismic shift
As Russia and OPEC continue to increase production, West Texas Intermediate reserves have increased faster than ever before, and are on track to mimic the historic increase in domestic reserves when the shale revolution began. Greater reserves indicate softer than anticipated demand, and typically foreshadow drastic corrections downward in price.
Unlike before, reserves aren’t increasing due to higher production; they’re increasing because the world economy has screeched to a halt. It remains unclear whether the American oil industry will ever recover, but for now unconventional methods such as fracking and tar sand extraction (as in the case of Alberta, Canada) cannot sustain the balance sheets incurred by their arbiters. Eventually these methods will emerge profitable at such low prices, but what they cannot do is withstand extended shutdowns; low rates have ensnared firms into fragile operating models, where the buffer against insolvency is paper-thin.
Sources
https://www.ft.com/content/eb8804fe-96e1-4eb0-a9c8-ef4626fbe8f5
https://whiting.com/investor-relations/sec-filings/
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.
