You may have heard the news about oil prices dipping to negatives for the first time in history. This means that people are literally paying other people (or entities) to buy oil from them to store. At first glance, this seems like infinite money, but sad to say, it's not possible for us to simply go and fill up our house with barrels of oil and get cash. It also doesn't mean we get to refuel our cars for free, either.
So how did this happen, and what does this mean for the oil industry and the world's economy as a whole? Let's find out.
What caused a negative oil price?
First off, it is important to note that you can't just go out and buy a barrel of oil at negative prices and have someone else pay you money. This is the real world where money doesn't grow on trees, sadly.
As we can see, the price for a barrel of oil never really dipped below $11 per barrel. Sure, oil prices are falling drastically, but they are not negative. So what's all this talk about negative oil prices?
Simply put, what went to negative prices was for oil future contracts under the West Texas Intermediate (WTI) index, which is an index for crude oil from US oil wells, typically used to benchmark the oil industry's prices.
An oil future contract is basically a contract made between two parties, whereby the buyer agrees to buy the oil at a future date for a specific price from a seller. The WTI futures contract is kind of special in the sense that when the contract expires, it is settled in physical barrels of oil, unlike other oil future contracts which are settled in cash, like the Brent futures.
This means that when the contract expires, the number of barrels specified in the contract becomes physical barrels that now belongs to the buyer. These barrels are usually held in storage warehouses that the buyer goes to in order to collect them for usage.
Therefore, when a WTI futures contract expires, holders of the contract have three options they can take:
- Let the contract expire while they own it, meaning that they have to take delivery of the physical oil barrels
- Sell the current month's contract to somebody else so it's not their problem anymore, and take any gains/losses on the contract price
- Sell before the expiry date and buy a new contract for a longer term, which effectively "extends" their futures contract
As you can see, the only way to not take delivery of physical oil barrels in the case of WTI crude future contracts is to not own it at expiry date. This can become a problem for one huge reason.
Most people that purchase these futures contracts are not people looking to actually use the crude oil. Instead, they are players of the market that are looking to use these futures to make money by selling them. In normal circumstances, this is perfectly fine.
When the futures get close to expiry, these traders will either sell these futures or roll them forward to the next month. In the end, those oil barrels will eventually go to entities that actually use them, like airlines, transportation services, energy plants and such.
The issue comes when these entities that actually have a use for the physical oil no longer want to buy oil. In such a scenario, these traders that can't take on physical barrels will be desperate to sell these contracts so they won't have thousands or millions of barrels of oil under their name that they have no use for.
This is because if they take on these barrels of oil, they will have to pay for the transportation fees, storage fees and all other fees associated with them, even as they have zero use for the oil.
On 21st April, 2020, the WTI crude futures contracts for May were expiring. As such, many traders wanted to close out their positions to not take on the physical oil. But they ran into a problem - there were no buyers of those contracts, because no one wanted oil.
Desperate to sell them to avoid the costs of owning the oil, they actually paid for people to take these contracts off their hands and take delivery of the physical oil, resulting in the negative prices of the May futures contract.
Currently, there is a lack of storage space available to store these barrels of oil, making it hard for buyers of the contract to store the oil after the contract's expiry. This is because the global demand for oil fell rapidly but production hasn't slowed, resulting in far more supply than demand. In short, there is now too much oil to store than there is oil being used.
As a result, no one wanted the futures contract as they had no space to store those oil. It became sort of a hot potato, where everyone tried to throw it to another person, even going as far as to pay money to toss it away.
The end result? Negative oil prices for future delivery - for a while, anyway. After the contracts expired on Tuesday, oil futures prices steadily went back up to a non-zero level, albeit at a very cheap price.
Other futures contracts like Brent are doing much better. Since they are fulfilled in cash when the contracts expire, buyers are not so concerned with having barrels of oil with nowhere to keep - they just end up with the cash as promised by the contract. Therefore, don't expect those futures to go to the negatives.
Investors like the oil industry as it reacts heavily to news and has a lot of volatility. In strange times like these, the oil industry is really going wild. Let's dig a little bit more and find out what's happening in the oil industry and how it will affect the global economy.
Oil is no longer wanted
At this point of time, the coronavirus outbreak is still ongoing.
While we see that the growth rate is starting to slowly drop from an exponential to a logarithmic one, that's still nearly one million people infected in the US alone. This is largely thanks to lock down measures by closing businesses and making people stay at home, but could quickly increase again should businesses reopen or people be allowed outside in masses.
In the US, we already have news about protests with people going "my body my life" and congregating outside despite stay home notices. We also have front line workers having not enough personal protection equipment like masks. All of these does not bode well for the containment of the coronavirus outbreak.
If history repeats itself (and let's hope it doesn't), the first wave of the Spanish flu only killed around a million people. That's still a lot of people, but it was nothing compared to the second wave.
It was the second wave of the Spanish flu that murdered. When the second major outbreak happened, it killed 20-30 million people. A major part of this infection happened in the high social classes due to gatherings. At its peak, the Spanish flu infected 500 million people, or one third of the world's population. Let's not repeat that mistake and allow COVID-19 to have a second wave.
In any case, as we attempt to stem the outbreak, we have shut down all forms of travel and issued stay home notices. Transportation goes down. There are less planes flying, no cruises, less cars... you get the idea. In a nutshell, the global demand for oil has gone down.
Still, that doesn't explain why we are running out of space to store oil such that futures contracts are going to negatives just to avoid having to receive physical oil. If the demand for oil drops, just reduce the supply by lowering production. Isn't it simple? Well, yes, but the real world is far from ideal.
The oversupply of oil
We all know that commodities follow a supply-demand curve. If the demand goes up, we increase supply, or find ways to meet that demand. After all, there's money to be made! The vice versa is the same. If demand goes down, we should be lowering demand to avoid over producing, which would result in our current problems of running out of storage space to store the leftovers.
So why is this happening? As it turns out, a few oil producing countries are throwing a tantrum.
The US is currently the world's largest producer of crude oil, followed closely by Saudi Arabia and Russia. The fourth country, Canada, doesn't even come close.
In early 2020, the petroleum producing countries had a meeting to slow down oil production in order to maintain oil prices at a reasonable level where they would all make more profits. However, the meeting fell through, resulting in an oil price war.
Russia refused to slow down production, forcing Saudi Arabia and US to increase production as well to maintain market share. While the original plan was to slow production to boost prices, now that the oil supply continuously went up, prices fell drastically.
It is important to note that US companies typical cost of producing a barrel of oil is higher than that of Saudi Arabia and Russia. In fears that the US would consume more market share if they slowed down production, Saudi Arabia and Russia decided to continue producing oil, confident in their lower cost of production.
A way to think about it is this. If Saudi Arabia and Russia both produce oil at $10 a barrel, and the US produces oil at $20 per barrel, then if oil sells at $15 per barrel, Saudi Arabia and Russia would still be making money while the US would be losing money. Effectively, they are still producing oil in hopes to garner more market share by causing US oil companies to suffer deficits and hopefully bankruptcy.
What we have now is a battle of attrition to see whether the oil companies of each country could bear the losses of oil prices falling and not go bankrupt. The side that goes bankrupt last would be able to dominate a market with little to no competitors left.
In addition, it is not easy to stop an oil well from drilling for oil, as the fixed costs to run these are usually very expensive. Stopping these would result in heavy losses as well, so most companies choose to keep them running, adding to the continued production of oil.
The sharp decline of oil demand due to the coronavirus outbreak, combined with the sustained increase in supply has resulted in a massive oversupply of oil. Normally, oil is used up as it is produced by airlines and other industries. Now, as businesses close, oil is sitting around unused.
The overproduction has caused storage spaces to quickly run out, causing the problem of no one wanting to own the oil as they have no places to store it.
Luckily, Saudi Arabia and Russia recently renegotiated a deal to cut oil production down - at least for the next few months, in view of the coronavirus outbreak severely lowering demand for crude oil. The US will soon follow suit, and all will be well again in the oil industry... right?
The argument for renewable energy
A reason for this oversupply of oil has been examined above - the companies that survive this period of loss will end up with a larger market share as competitors die out. However, if we look at this closely, is the current losses worth the gains in the future, or is there some other underlying reason?
An argument that we can make is that the federal reserve will bail these companies out, allowing them to go on a rampage and produce whatever oil they want knowing that they will not be allowed to go bankrupt. In fact, Donald Trump has pretty much already promised to bail them out. Yes, with taxpayers / imaginary money from the money printer. Brrrrr.
However, another reason to consider is the advent of renewable energy. It is undeniable that the world is slowly moving towards the use of renewable energy instead of fossil fuels. In fact, it already makes up more than 17% of the US's energy generation needs, and is expected to grow rapidly as more technologies are invented to better harvest solar, wind, nuclear and hydro energy.
The side effect of such a rise in renewable energy is that the oil industry will falter. Today, the bulk of crude oil consumption comes from transportation and industrial uses (like the production of plastic). Nearly 70% of crude oil used in the US in 2017 was used for transportation, and 20% for industrial uses.
While the industrial use might not see much decline, barring a more environmentally friendly and durable replacement for plastics, transportation as a whole is rapidly changing. Already, we see automakers like Tesla taking over the automotive market with electric cars, prompting other automotive makers to quickly research and push out their own electric vehicles.
In the future, as technology gets better, aviation could switch to electric planes as well. When we have both cars and planes running on electricity which is produced through renewable energy, crude oil consumption will heavily decrease. Demand would reflect current levels, where there is not much use for transportation purposes.
In lieu of this future, the oil industry would quickly see themselves diversify into other sectors, slowly shifting their monolithic operations from oil into other sectors and industries. Could this be a reason for the overproduction in oil? Perhaps. After all, if oil as an industry will slowly die in the future, it is better to try to kill off all competitors now and milk the last bits out of it instead of taking huge losses in the future fighting over scraps.
The future of oil
So what is the outlook on the oil industry in the future? Currently, oil futures contracts are still at an all time low for the next month, as the coronavirus lock down is expected to continue.
The more optimistic among us feel that oil prices will pick up in the latter half of the year as the number of new cases go down and things go back to their usual routine.
If the Spanish flu had anything to learn from, we should be worried, however, about the massive repercussions of a second wave of the outbreak should normal operations resume. If congregations are allowed in the latter half of the year and COVID-19 reemerges, things could get ugly fast.
While the first wave of Spanish flu sufferers that recovered developed immunity to the second outbreak, we know by now that people who recovered from COVID-19 do not develop immunity against the virus. This could be due to the virus fast mutation or some other reason. As of 22nd April 2020, we don't actually know yet.
In that case, resuming normal operations would be a huge mistakes. The virus could spread again, and develop even more mutations and immunity against modern medicine and our immune system, proving to more infectious- and more deadly, than the first wave. It could be Spanish flu 2.0 all over again.
Therefore, the more pessimistic among us would expect this state of lowered transportation to continue into the foreseeable near future until we can be sure that COVID-19 is reliably snuffed out - or at least, until we find a vaccine.
In such a dampened scenario, global demand for crude oil would remain low and oil prices would not recover well.
In the long term, if we expect renewable energy to be king in the future - which it will, then crude oil's demand will begin to fall off gradually into the future. After all, it is a limited resource, while renewable energy, as the name suggests, is virtually unlimited. Without a doubt, if humanity is to survive into the future, we would need to move to a sustainable source of energy.
All in all, we are not very optimistic about crude oil right now. The landscape is tumultuous, and it is highly risky to jump in right now.
Oil and the economy
The sharp rises and declines of oil has had large impacts on the economy. This shouldn't be surprising - remember when we said that the two largest usages of oil is for transportation and the production of industrial materials like plastics? Oil literally is the backbone of the economy since it involves getting goods and materials to producers, suppliers and consumers as well as the production of said goods.
Oil actually has a rather interesting relationship with the economy. When oil prices go up, the economy gets hurt because the cost of producing and transporting goods go up (since oil is used to produce and transport goods).
When oil prices go down, however, the economy is usually not doing so hot either. If oil prices drop, it means that supply has outstripped the demand. Why would demand decrease? Simply, it means that people are spending less on goods and travelling less, resulting in less oil being consumed for goods production and transportation.
So if you think about it, no matter what happens with oil, the economy is hurt! Well, in the former case, an increase in oil prices is actually a good thing. It means that people are spending more to buy goods and transportation is in demand, so supply is less than demand. Generally, it actually means that the economy is doing well, despite the higher costs of goods production.
In this COVID-19 apocalypse, however, we have an artificially induced recession. We discussed this in one of our earlier articles, whereby we mentioned that this is a recession caused by a virus, not a natural recession caused by a crash. The results of this is... unknown, since this has never happened before in history.
In other words, all these "symptoms" of a recession like reduced spending, transportation and whatnot are so called artificially induced by the virus. Remove the virus, and all that spending will come back - quickly. Of course, it's easier said than done. If the Spanish flu is anything to go by, the coronavirus is here to stay for a while.
If that's anything to go by, the oil industry will be in tatters for a long long time, and so will the economy.
In a nutshell, the oil industry is a mess right now. If we want our economy to improve and our lives to return to normal, we must not repeat the same mistake as the Spanish flu era people did. Stay safe and stay home. That is the most important thing to do right now.
Should a second wave outbreak occur, we will not be able to bear the consequences of it.
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