Strange Times

Last week the U.S. oil contract closed at a negative price: an astonishing -US$37.63/barrel for a thousand-barrel contract for May delivery. A negative oil price sparked interest one night at my dinner table, with my children wondering whether they could supplement their pocket money by walking up the hill to the local B.P. service station and be paid to take petrol away in buckets. To their chagrin, I had to burst the bubble of this money-making scheme. Still, as an economist, it was difficult to explain the concept of a negative price for a commodity with both an inherent value in use and a production cost.

This unprecedented move in the oil price comes after a few years of negative interest rates in Europe and the prospect in 2020 or 2021 of negative interest rates in Australia. Negative interest rates are something unprecedented in human history, ever since interest rates were first set in Babylon by Hammurabi in 1772 B.C. We certainly live in strange times that are not easily explained by traditional economic theories that have held for thousands of years. In this week’s piece we are going to look at how we have arrived at a negative oil price, where producers are effectively paying customers to take their product off their hands.

Costs of production

The costs of extracting oil vary globally by both geography and extraction method, with a worldwide average between US$30 and US$40 per barrel. Shale oil in the U.S. generally costs more than conventional oil extracted in other places from large underground reservoirs, with costs ranging from a cost-per-barrel of production from as low as $40 to over $90 a barrel. Costs can be brought down with improvements in hydraulic fracking technology. In Australia, Woodside has a low cost of production at US$4.50 per barrel, though this metric ignores the tens of billions of sunk costs required to build the offshore oil rigs around 100kms off the coast of W.A., as well as the related onshore infrastructure.

U.S. shale oil is extracted using a large number of small, cheap, short-production-life oil wells, which allows these producers to reduce supply by stopping drilling new wells when prices fall. Conversely, conventional oil fields such as offshore fields require considerable upfront costs to develop, but have a low ongoing cost of production. These fields will almost always stay in production regardless of the global oil price, often just to service the interest costs from the debt taken on to develop them.

Unprecedented fall in demand

The Covid-19 crisis has seen a very sharp decline in global demand for crude oil with airlines grounded and motorists quarantined, as around 70% of global petroleum consumption is used in the transportation industry. The step-change in demand can be seen in the traffic data released by toll road owners. For example, Transurban reported a 50% fall in average daily traffic in Australia, and Atlas Arteria had a 67% fall on their roads in France and the USA. Similarly, large U.S. airlines such as Delta reported a 95% reduction in flights in April, with planes stored in arid places such as Tucson, Arizona to reduce the corrosive impact of moisture on dormant planes.

The fall in demand for crude oil has seen storage capacity fill up in the United States in 2020, as oil extracted in January and February made its way via pipelines from the wells in Texas and Arkansas to the storage facility in Oklahoma. At the same time, the two heaviest users of oil suddenly had little use for oil as refineries stopped buying crude and petrol stations and airlines curtailed their purchases of petrol and aviation gas.  The storage systems for oil, particularly in the USA, never envisaged such a fall in demand almost overnight.

Historically the U.S. has been the world’s largest oil importer, though this began to change in the mid-2010s with the rise of U.S. shale oil. In 2019 the USA moved to become an oil exporter. Since the U.S. is only in the early stages of transitioning from being an oil importer to an oil exporter, their existing oil infrastructure remains primarily oriented towards moving imported oil from the coast to major cities, not exporting from Texas and Arkansas to Europe or Asia. As a result, there is a lack of infrastructure to store domestic oil in the interior of the U.S.

  What usually happens when oil prices tank?

Typically, during times of weakening global demand the global oil cartel OPEC+ (OPEC plus Russia) agree to cut production to maintain global oil prices. In early March 2020, the outlook for global demand was looking grim: the world’s biggest oil importer (China) was turning away oil tankers, and Western governments were debating the need to implement lockdowns to prevent the spread of Covid-19.

However instead of managing production to halt the fall in prices, the Saudis and Russia entered into a price war on March 8th, after the Russians refused to reduce production. On March 10 the Saudis announced that they would increase their production from 9.7 million barrels per day to 12.3 million, while Russia planned to increase oil production by 300,000 barrels per day. These actions flooded global oil markets with additional supply at a time when demand was falling sharply. At the same time, U.S. shale oil companies continued to produce despite lower prices to generate cash flow to pay the interest due to banks and bondholders.

Since 2008, daily production in the U.S. has doubled to 13 million barrels of oil a day to become the largest producer in the world. Historically, U.S. presidents from Jimmy Carter to George Bush have made pleas to OPEC to increase oil production in times of economic stress to cut the oil price in order to stimulate the U.S. economy.  However but in April 2020 President Trump threatened to pull U.S. troops out of Saudi Arabia if the Saudis did not make moves to increase the oil price to help save the jobs of U.S. oil workers.

Different oil prices for the same product

There are two main oil benchmarks used globally: Brent, which is the most popular and is based on the light sweet crude oil that comes from fields in the North Sea, and West Texas Intermediate (WTI), which is used for land-locked U.S. oil that goes into a pipeline that ends in Cushing, Oklahoma. The Brent oil price has not fallen as far as WTI, and has not descended into negative territory since it does not face the storage issues outlined above. Brent crude is priced from oil sourced in the middle of the North Sea and is also used to set the price by OPEC. In both costal Europe and the Middle East seaborn tanker storage is accessible and flexible, while WTI oil storage in Oklahoma is limited. As a result, the Brent price of oil has been more protected from the coronavirus-related demand shock, while WTI prices were much more sensitive to that factor.

How prices go negative

NYMEX (New York Mercantile Exchange) crude oil futures are the primary “price” for U.S. oil, with oil consumers such as refineries buying these contracts to lock in future supply at a specific price. Buying this futures contract provides a price per barrel for 1,000 barrels of oil to be delivered to a massive oil logistics hub in Cushing, Oklahoma over a specific month. Oil producers sell contracts to lock in prices for future production which are bought by refiners and storage entities to lock in prices for future purchases. Additionally, oil contracts are sold and bought by oil traders and financial entities such as hedge and commodity funds to profit from changes in the oil price.

When a buyer holds an NYMEX oil contract at its expiration, the owner has the obligation to take physical delivery of this oil at a specific place in Oklahoma. Normally, before contracts expire traders sell their contracts to demand sources that can take delivery, like refiners or oil storage, with minimal impacts on prices. However, storage facilities are finite. Now Cushing’s storage of 76 million barrels is close to full due to the drop in demand from Covid-19 and limited means for oil to flow out from Oklahoma onto the world market.

Hedge funds and exchange-traded oil funds had bought these May NYMEX contracts in late 2019 seeking to profit from a rise in the oil price, but were faced with a situation where:

1)    They could not find a buyer for the oil contract before it expired;
2)    They did not physically want to take delivery of thousands of barrels of oil at an office in Houston or New York; and
3)    The Fund had trouble finding a place to store the oil to wait for a higher price later in the year.

In this situation, the hedge fund owners of the May oil contract were forced to pay buyers US$37 a barrel to take the NYMEX oil contract off their hands, thus resulting in a negative price for a commodity that likely cost around US$40 a barrel to produce.

Will this make petrol prices in Australia to fall further?

Sadly no. While petrol prices in Australia have fallen to below A$1 a litre, the negative $37/bl (158 litres of petrol in a barrel) is a localised event in the central U.S. and does not represent a global price, nor reflect the price to ship oil to Australia. In any case, around 40% of the price that Australians pay for petrol is comprised of fixed government taxes that are applied regardless of the world oil price. Excise is fixed at 42c per litre (regardless of the world price) plus 10% GST, and it costs around 15 cents per litre to refine oil into petrol, and there is also a cost in getting it to the petrol station.  This equates to an Australian floor price of 63c per litre, excluding the price of actually getting the oil out of the ground and shipping it to an import terminal in Australia.