An offshore oil rig in the North Sea
So, a guy drives into a gas station. The attendant walks up as he opens the driver’s-side window. The attendant asks the guy what he wants. The guy says “fill it with regular” and then rolls up his window. The attendant returns a few minutes later with a wad of cash, gives it to the guy and says, “Thanks, we’ve been trying to get rid of gas.”
Crazy, right? Well, something similar happened yesterday in the oil market. The price of West Texas Intermediate Crude futures for delivery in May went negative. Those contracts, which expire today, dropped by 300%. They were selling for -$37.63 a barrel.
What in the world is going on? To answer that we need to explain how a futures contract works. From Investopedia: A futures contract is a legal agreement to buy or sell a particular commodity or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is obligated to buy and take delivery of the underlying asset when the futures contract expires. The seller of the futures contract is obligated to sell and deliver the underlying asset when the futures contract expires.
The Demand for Oil
So, futures contracts involve actual delivery of the underlying asset. In this case, oil. Right now, the world is awash in oil. Demand has collapsed because the Coronavirus has shuttered much of the global economy. Transportation makes up 60% of the demand for oil. Planes are grounded. Ships are docked. Cars are garaged. Hundreds of millions of people are not moving around very much. The need to transport goods, while not as severely impacted, has also fallen.
The Supply of Oil
Basic economics tells us that a drop in demand results in a drop in price, assuming supply remains unchanged. However, right now we have an over-supply of oil. A few months ago, the Russians and Saudis got into an argument over control of the global oil market. They both opened the spigots and flooded the world with oil. Other major producers, including OPEC and the US, kept producing at normal, or even elevated, levels.
When demand goes down and supply goes up, you have a formula for a price collapse. That is exactly what is happening right now. The scale of this imbalance is unprecedented. You can add this to the long list of mind-boggling economic consequences of the Coronavirus outbreak.
We have a situation where there is so much oil that storage has become a major problem. Oil producers have filled their storage tanks. Governments have filled their emergency reserves. The US Strategic Petroleum Reserve will soon be full. Massive amounts of oil are loaded in giant supertankers (so-called VLCCs, or Very Large Crude Carriers”) floating all over the world. The daily rate to charter, or rent, a VLCC has correspondingly increased from $29,000 per day to over $100,000 per day.
You might be thinking, “Why don’t these producers just stop producing oil?” It’s not that easy. It’s expensive and time-consuming to ratchet back production. Producers also fear losing market share. So, in the short-term it may be less expensive to them to essentially give away oil rather than stop producing it. In the case of the May futures contract, producers were effectively willing to pay buyers to take delivery of oil.
Correcting the Imbalance
How will this market correct itself? That process was set in motion last week when Russia, Saudi Arabia, OPEC and the US agree to cut production. That cut should take 10-15 million barrels per day out of the global supply. But that may not be enough to shore up the market. Demand continues to drop. Until the Coronavirus is under control and the global economy comes back on line, the price of oil will continue to be under pressure.
The good news is that yesterday the June contract dropped by only 10%, to $22 a barrel. So, the futures market seems to think things will get better.
We wish you health, peace and happiness.
Note from Springwater:
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