A crude conundrum

Over the past couple of days we have been treated to the spectacle of negative oil prices with the price of the West Texas Intermediate benchmark closing yesterday at minus $37.63 per barrel. Strictly speaking, it is only the price for delivery in April which has turned negative – the price for delivery in subsequent months remains positive with the May contract ending yesterday at $20.43 (although it slipped to $10 in the course of today). Nonetheless, it raises a number of interesting questions about how market-clearing prices are determined at a time of such huge uncertainty and the outlook for oil markets, in both the near-term and longer-term.

Dealing with the price setting question, in the current situation oil traders are paying prospective buyers to take oil off their hands rather than the other way around. But this is a result of the specific conditions in the oil market. Traders have to settle their forward contracts with physical delivery of crude oil and were desperate to avoid taking delivery of additional oil ahead of today’s settlement date because demand has collapsed to a far greater degree than production. As a result there is insufficient storage space to accommodate the supply glut, which has prompted the collapse in prices in order to restore market balance.

This runs contrary to the way we think of the price-setting process. After all in Economics 101 classes, the supply-demand diagrams always assume that the market-clearing price is positive. But negative prices happen frequently in the electricity market when suppliers sell their output into the national grid. For example if there is a sudden surge in electricity supply generated by renewables which exceeds current demand, the supplier has to supply it to the grid at a negative price. In time, as the generation company is able to adjust supply so the price is forced back up again. This is the key to understanding the current predicament: The burden of adjustment falls fully on prices when supply is unable to adjust (i.e. it becomes totally inelastic), which is precisely what happened in the oil market just ahead of the contract settlement date.

In the wake of the financial crisis, we learned that interest rates could turn negative and now we know that certain commodity prices can also turn negative. But it is not a sustainable situation. If you recall your basic economics, short-term profit maximisation is achieved by setting the selling price at the marginal cost of production. However low production costs may be in places like Saudi Arabia, marginal costs are not negative. In the longer-term, producers will also have to cover their fixed costs. But this raises the question of what is the longer-term equilibrium oil price?

This requires some idea of underlying demand/supply conditions. The International Energy Agency predicts that global oil demand will fall by a record 9.3 million barrels per day in 2020 relative to 2019 (a decline of around 10%). But supply is predicted to fall by only 2.3 mbpd so it is evident that the supply glut which was exacerbated by the Saudi-Russian price war is not about to get any better. The six month contract for WTI, which expires in October, is currently trading at around $25/barrel. Although this may not necessarily be a good predictor of the price six months ahead it is a reasonable proxy for how industry specialists view near-term prospects. For a number of major producers, this is too low to be profitable. According to a 2016 article in the Wall Street Journal, the cost structure of producers such as Brazil, Nigeria, Venezuela and Canada is such that they would struggle to break even if prices remain at these levels (chart below). It would also be bad news for US shale producers whose costs were estimated at $23/barrel. To the extent that shale producers have played a major role in changing the dynamics of global markets in the last decade, a reduction in US output would certainly help to put a floor under prices.

Nonetheless, it seems likely that in the near-term, global oil prices may struggle to exceed $30. That is bad news for those countries which rely on oil as a major source of revenue (it may also be bad news for Newcastle United FC which is reportedly the subject of a takeover by a Saudi-backed consortium). If low prices are sustained in the longer-term, this may act as an obstacle to weaning the world away from fossil fuels since it will be difficult to generate low-cost energy which can compete with oil. However, under normal circumstances prices would be expected to rebound quite quickly as the global economy recovers, which would render this concern redundant. But much will depend on the behaviour of the main producers. OPEC has found it difficult over the years to maintain production discipline and the recent spat between Russia and the Saudis suggests that producers want to maximise their revenues while they still can.

Maybe one day in the future we will look at the collapse in oil prices and regard it as a blip, in much the same way as the price spike of 2008 is now viewed. The savage nature of the economic collapse as the corona shutdown drags on means that many of our preconceived ideas about what is possible are having to be reviewed. However, the recent price collapse may also reflect the shifting tectonic plates of the oil market. This could be the start of a new regime in the world of fossil fuels.