Another record breaker as the day WTI (North America’s most common measure for the price of oil) fell $50 in 2 hours. Listen to GLC’s latest podcast for insights into oil prices.
Greetings, this is Brent Joyce, Chief Investment Strategist at GLC Asset Management Group, and this podcast was recorded on Thursday, April 23rd, 2020. Welcome and thank you for tuning in. Today we are going to look at ‘What the heck is going on with oil prices?’
In case anyone hasn’t noticed, oil prices are now going haywire! So, first equity and credit markets saw huge intraday, daily and multi-day price swings now the mayhem has migrated to the oil markets. So the questions are what gives? Why oil now, why not weeks ago when everything else was going nuts?
Let's start by saying that April 20th 2020 will be remembered as the day WTI (north america’s most common measure for the price of oil) fell $50 in 2 hours. Another record breaker and another historic event to add to the many that have already been clocked thus far during this crisis. It wasn’t just WTI, making history, many oil futures contracts recently traded near zero or slipped into negative price territory– yes you heard me correctly – negative prices mean someone had to pay to get rid of barrels of oil… and pay handsomely, the contract went as far negative as -$40 and closed the day at -US$37.63, the lowest level in 150 years of recorded data. Canada’s Western Canadian Select crude oil contract didn’t go negative but touched down to 13 cents a barrel to mark an all-time low. I would note that the week also featured Earth Day, don’t think the irony isn’t lost. But in reality, if you had 159 litres of crude oil in a metal barrel in your front yard, how much would you pay someone to take it away? Maybe $40 bucks is cheap? This is precisely the predicament futures traders in the WTI contract faced.
But what happened? How did we get here? Why the sudden drop to historic lows?
We have to remember that there was already a fragile supply – demand dynamic in oil markets globally and then you drop COVID-19 on the world and we see demand start to collapse. First from China as early as January of this year and then of course spreading as travel bans, border closures, and lockdowns drastically cut oil consumption. What was a small monthly global production deficit (more demand than supply) at the end of 2019, that was hopefully going to slowly work off bloated inventories, quickly swung to a surplus, more oil than we need. Initially, 3 mbpd in January, 4 in February, 9 and a half in March, and estimates peg it at 15 and a half mbpd in April. That’s a cumulative 32.5 million bbls/day for 4 months or 3.8 billion bbls of more oil being pumped out of the ground than the world can currently consume. If we aren’t burning it in cars and planes it has to go somewhere. And that somewhere is storage and storage capacity is filling up fast, especially in North America.
Here is a few fun facts, did you know:
That we now have 10% of the global oil tanker fleet floating around in the oceans as floating storage. Oil in floating storage sits at a record high at 160 million barrels a 100-percent increase over early April.
And railcars are being rented, not to transport oil, but simply to house it, stacked up in places like Grande Prairie or Brandon Manitoba.
Even the U.S. government is thinking about leasing out space in their Strategic Petroleum Reserve. The SPR, as it is called, has a capacity of 713 million barrels of crude, but is currently filled up with 635 million barrels, so just 78 million barrels of space remain. Private operators have space in tanks and pipelines and even railcars, but keep in mind a typical rail car can hold just 700 barrels, so many thousands would only make a dent.
But where ever storage exists, there is money to be made. Storage operators can make a fortune right now with storage in such high demand.
The problem is there isn’t enough storage space to go around if producers keep pumping. Market imbalances usually get fixed through a combination of adjustments between both supply and demand. So…how do you solve oil’s over-supply problem when the demand-side is locked down and unable to respond? The reality is you can’t, the supply-side is all you have – this is part of why what we are seeing has never happened before. Enter extraordinary, historically low and even negative oil prices. Low or negative oil prices are the best mechanism to force oil to stay in the ground for now. – it is a job that financial markets are meant to do. Market pricing mechanisms are more powerful than any cartel or government mandated production cuts. Cartels and cuts are only shutting in ~10mbpd of production, the world needs to, temporarily at least, stop pumping between 20 to 30 mbpd, at least until demand starts to recover as economies begin to slowly open up.
The storage capacity problem is very much at the heart of why oil traded negative for a brief period this week and why we are seeing different prices for oil with widely varying price ranges. The difference between a barrel of WTI and a barrel of Brent crude oil was more than $60 at one point, these two prices usually vary, but by $5 or $10, not $60.
The answer lies in the fact that oil prices are derived from the futures market and in the commodity futures market there are two types of contracts: physical delivery and cash settlement. All physical delivery futures contracts require three ingredients: what, when and where. What is what kind of oil - as there are different blends, when is when will it be delivered and where is where will it be delivered.
So the prices that went to zero or negative are all physical delivery contracts for many varieties of crude – WTI, WCS, Mexican Mayan Crude to name a few and the places for delivery are the delivery points like Cushing Oklahoma for WTI or Hardisty Alberta for WCS for example. A further complication in this week’s negative pricing is the fact that Cushing and Hardisty are land-locked delivery hubs. The most important factor this week became the time for delivery.
This week’s historic events only happened to physical delivery contracts and it was only the front-month contract for May physical delivery that went negative. Physical delivery is exactly what it sounds like. If you hold that futures contract at expiry you are on the hook to provide or receive the physical commodity at the prescribed time and place. This is fine if you actually want to buy or sell the oil and have a container to get it to and from the market. Now the market itself will hold the oil for you if they have space – this is why Cushing OK or Hardisty Alberta aren’t randomly chosen places; it is because these are home to massive tank farms and underground oil storage facilities that measure into the tens of millions of barrels. But a combination of rapidly filling storage capacity and rising storage costs squeezed futures traders and prices fell rapidly as the expiration date of April 21st for May delivery approached.
So, there are two answers to the puzzle of what the heck is going on with oil prices here: One is the negative prices are somewhat of a quirk in the futures market that if it wasn’t well understood by market participants before this week they literally had a crash course this week. The other nuance is why not all oil prices went negative – namely the other widely quoted oil price which is Brent crude. WTI is a physical settlement as discussed. Brent crude is a cash-settled futures contract, so an option exists to avoid physical delivery and to simply settle up with a cash payment between parties. There are pluses and minuses to each type of contract. The plus for physical settlement is the closer connection to the actual commodity market, the minus is pretty much the same answer…trading can get wild near the expiry date of the contract. And the opposite for cash settlement, it isn’t an exact representation of the physical commodity, but it is less likely to go crazy as expiration approaches too.
A little side note here, when the May WTI contract finally did expire mid-afternoon on April 21st, the last price was $10 on very small volume as these last remaining contracts would be those where the actual physical settlement was preferred. Physical delivery futures contracts should equal a ‘true’ spot price at expiration and that price wasn’t negative.
It is important to note that the Brent crude contract price also fell hard, but not -308% into negative territory like WTI. Brent Crude was only down 10% on the same day WTI went negative, fell another 37% on the following day to $9, but has since been rebounding by over 100% into the mid-$ ’20s. It is also important to note that, once the May month rolled off for WTI and all the long traders got squeezed (a bit of the opposite of a short squeeze in stocks) on April 22, the June contract became the new front-month contract and promptly the WTI benchmark quote rocketed up over 100% in a few hours as the June contract (that has not yet traded negative) went from $7 to over $14.
This brings up an important question, will we continue to see these crazy and negative oil price swings going forward? The answer like many things at the moment is maybe.
If conditions persist, and oil production I North America doesn’t get cut back, then yes – storage will hit what insiders call “tank tops”. This doesn’t mean all the tanks are actually full, but that they are very close to full and all the storage capacity is contracted out. Forecasts for tank-top conditions are currently running at weeks, not months. Also, there is oil on the ocean currently headed toward North America; oil from the middle east takes months to ship and a sizeable amount is set to arrive over the next 6-8 weeks, so this problem might getworse before it gets better. This is actually a surge in exported oil due to actions that Saudi Arabia took in its opening salvo in the price war with Russia that began in early March. Saudi Arabia wanted to back-up its price war threats with action, so… they flooded the market with oil, filling ships and sending them off to customers. So it is a confluence of all of these factors that are hitting oil prices very hard.
So North American production does need to decline. And low prices are starting to have their intended impact. As of April 17th, active oil rigs in the U.S. are down to 438 from 683 back in February that is a decline of 36%; in Canada, just seven conventional rigs are active, down from 172 back in February a decline of 96%. Herein too lies a problem, shutting down rigs costs money in terms of foregone revenue, but there are fixed costs and risks as well. Producers need to pump some oil in order to maintain operations, things like keeping temperatures and pressures at levels necessary to keep wells and reservoirs in shape for future production are necessary. Producers face trade-offs between reducing volumes without damaging operations, and racking up future costs to restore production later against potentially having to pay or accept uneconomical prices to offload the output from these sustenance levels of production. In this context, negative prices for oil are a form of waste disposal, just like the barrel of oil sitting in our front yard that I mentioned when we opened our discussion. There remains a ways to go on the shutting in of production, so near-term futures prices are going to stay volatile for several months and the June contract going negative can’t be ruled out, although presumably traders will learn from the experience of this past week.
Beyond the next few months of markets needing to hash-out these near-term forces, longer-term where do we see things? At some point, demand will begin to rise again and supply will have been curtailed, prices will do that. When that happens is as uncertain as everything else related to the coronavirus. However, If economic activity slowly rebounds over the next several months and OPEC and Russia hold to their current two-year commitment to keep 9.7mbpd of production off the market, excess supply will get worked off over time and prices would need to settle back toward the $50 mark where the marginal cost of production equals the demand. This isn’t likely until deep into 2021 and until then we see prices in the $30 range through the end of the this year and maybe into the $40’s next year. Although the futures prices for June 2021 are only into the low $30 range at the moment – but they are still reeling from this week’s wake-up call.
Encouragingly, at the sector level in Canada, the energy sector was much less volatile this week than the spot prices would have suggested– the S&P/TSX energy sub-sector is about flat on the week to Thursday and flat over the past two weeks. Similarly, the Canadian dollar often a very oil sensitive currency is flat on the week and down less than 1% over the past two weeks, suggesting far less concern over oil prices than the flashy headlines would suggest. But the energy subsector on the TSX was down 54% a few weeks ago, has bounced up 35%,but that still leaves it down 35% on the year.
The stocks have sold off sharply, but unlike a futures contract, a stock can only go to zero and in general that’s not where we are at. Some businesses will need to be rationalized as the industry moves through this, the credit market is at risk as some companies will face default. The dividends from the industry are already being cut and we would expect more to come. The bottom line is we see the energy industry facing tough times for quite a while.
Thank you for listening to this podcast, we hope you found it informative. We wish you well, stay safe and for more of our views and insight into our investment portfolios please visit us on the web at glc-amgroup.com, you can also find GLC Asset Management Group on LinkedIn, or follow us on Twitter under @glcasset.
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Copyright 2020 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).
This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.