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.
