April 26, 2020 § 2 Comments

On Monday this week, traders paid to unload oil purchase contracts known as futures. The price of oil went negative. Story lines had titles about being paid to fill gas. But, sorry, you will not be paid to fill up your gas tank. You already knew that because business does not work that way. What may surprise you is that some gas station owners are commanding better margins right now than before. Some explanation for the conundrum follows*.

The real price of oil, the price folks actually using it are prepared to pay, never went negative.  This was an artifact of commodity trading. Traders buy oil for delivery sometime in the future. They never intend to take delivery. They are speculating on the price rising prior to the delivery date, netting a profit. When they are wrong, they sell the contract to someone at a loss. This one was a doozy of a loss. Because of the precipitate action of many traders on the same day, the price of oil plummeted, going to a negative USD 37 (see graph in the link). They paid someone to take that oil off their hands. To underline the transient aspect of this event (no matter the chicken little headlines), at this writing a scant few days from the plummet, the price is just over USD 17. Not munificent, but not negative.

Futures trading in oil in the US is different from that in Europe. In the US, oil delivery must be taken in Cushing, Oklahoma. Traders caught in the squeeze described above have the option of storing it in Cushing for a while. Not this time. No spare capacity was available. Brent oil futures take delivery at a port in Europe. Brent May futures dropped just 2 dollars. This Cushing pinch point feature, together with other bottlenecks in pipeline transport, are the reasons why West Texas Intermediate (WTI), the US benchmark, always is USD 2-5 below the Brent price. This despite the fact that the oil is sweeter (less sulfur) and lighter. 

The majority of US oil produced today is shale oil.  This is light and sweet and when distilled in a refinery, over 90% comprises useful transportation fuel gasoline, jet fuel and diesel. Only 5% is a residue known as fuel oil, which also can be burnt for heat. The problem today is that gasoline and jet fuel have plummeted in demand, but diesel has kept up reasonably because of farm use and increased truck traffic for deliveries. A refinery today can get crude oil for a very low price. It can sell much of the diesel fraction, but the gasoline fraction (usually more than the diesel fraction) has low demand. Yet, to produce diesel, gasoline is also produced. The result is that the gasoline is sold to the distributor at a very low price. But, according to some reports, some retailers are not passing on all the savings, with the result that their profit margins are higher than they were in normal times. That may be scant comfort with the low volumes. But in recent times, the convenience store associated with the pumps has been the profit maker, not the fuel, and that volume likely has not dropped. You will also notice that the spread between the pump price of gasoline and diesel has increased substantially.

Oil price is likely to remain low until the demand returns in some measure. Demand is estimated to have dropped by 27 million barrels per day (bpd) in April. OPEC + (OPEC plus Russia) agreed to a 9.7 million bpd reduction in output. The Texas Railroad Commission considered forcing a reduction of 1 million bpd and hoped to persuade other US jurisdictions to reduce another 3 million. After a critical meeting this week, two of the three commissioners voted it down. That leaves the supply/demand imbalance too high to put upward pressure on price. President Trump wants to top up the Strategic Petroleum Reserve (SPR) from the current 635 million barrels to 710 million. Congress is still to approve the cost to do that. The average cost of of oil in the SPR is USD 28. A top up at current prices would be a good deal. But the rate of fill cannot exceed 0.5 million bpd. So, it may not make a material difference. What will make a difference is wells being shut in. Companies will go bankrupt and be swallowed up for dimes on the dollar by the big ones, who have the deep pockets to hold on for better pricing.

Negatively priced oil was a mere curiosity. The over USD 50 price drop in a day was driven by trader behavior. That is unlikely to repeat. Many states are relaxing restrictions. Tracking already shows more people on the move. Schools are likely to open in some jurisdictions. Expect oil prices to hover in the low 20’s in the near future. That will not be enough for many producers, who will shut down their wells, which in turn will cause prices to firm. In other words, supply/demand drivers will return, and the aberrant negatively priced oil will be a story for the ages.

Vikram Rao

April 26, 2020

*this piece was driven by a request from three regular readers of this blog.



  • Abe Palaz says:

    There is also an international part to your explanation. Saudis were dumping oil to the US and have been the main reason for this. Early last week tankers loaded with Saudi crude heading to the US for May delivery amounted to 50 MMBO if you could just count the tankers. For the previous year, Saudi export to the US averaged around 500KBOD, and why on earth suddenly for May it was nearly 2MMBOD? Saudis were dumping the oil to the US market, and feature traders in Chicago failed to understand the situation and got too much oil in their hands. Traders did get their hands clapped as you explained the system could not handle such an attack. There was so much news about the -$37 oil but not much light as to why? There was no mention of this dumping. I heard some senators from Texas and others complained, but they soon silenced.
    As you know, mid-April OPEC+ had a meeting when they agreed to cut production by 9.7 MMBOD starting May 1st instead of immediately following the meeting. It was apparent OPEC+ was for two weeks continued to produce oil at unrestricted rates. All OPEC+ members knew well that there were no buyers anywhere on the planet, and most storages were near capacity. Saudi lead operation with US approval to dump Saudi oil into the US market. The consequence of this was obvious. To kill the high-cost oil, and return to the rule of low-cost oil. President could have taken some action, but after he met with the CEOs of all majors, he decided to do nothing, and he too stayed on the sideline. I think this attack on high-cost oil will play into the hands of US majors as they will eat up high-cost oil assets as you say 10 cents a dollar and save it for later days. I do not want this to go on any further and accept that I would not have done much differently. Too many producers were producing oil at a high cost that was, at this time was NOT necessary or needed. There got to be a way to shut them off, and Saudis played throwing away 50-100 MMB of oil to make this happen. Many jobs will be lost in oil-producing states I assume the Republicans calculated that well. Democratic candidates, when debating almost all seem agreement against fracing. The oil industry knows who their friend is for sure. After all, it was the oil industry that made the US energy independent in nearly a century. Now again was willing to sacrifice. If it was not the US oil industry, where would be OPEC+ and oil prices? West Texas can be saved for the future as a strategic reserve so long as we have the right people and skills in the service sector still survived. I have many of my colleagues laid off in Halliburton or Schlumberger. US oil industry depends on the service sector as oil companies can not survive without them.
    I am not sure what will happen now; the shale oil is hit and is downsizing significantly also deep, and ultra-deep productions are off the plans. Oil prices hover around high teens or 20s, which will not be suitable for any of the OPEC+ producers. I expect in the first half of May OPEC+ to meet or conference call to cut production ramping up to 20MMBOD; otherwise, we will even shale oil shut in have excess oil in the market. The immediate term they have to meet again to see how they can increase the cut to near 20MMBOD, otherwise killing the US shale oil would accomplish nothing for them. Consumers around the world are benefiting from low prices. Now the world, particularly OPEC+ producers, knows too well. If the prices go up, shale oil will be back into the equation. I think the entire world must be thankful for the US oil industry for bringing such a high price regulator to the market.
    I would like to hear your opinion about the impact of COVID 19 and low oil prices on global air quality and potential changes in social behaviours.

  • rtecrtp says:

    OK, let me see if there is enough grist for the mill of air quality impact and behavior change to merit a blog. I did write a bit about it in an earlier blog.

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