The coronavirus pandemic caused an economic
shutdown, unlike the world has
ever seen. The US economy, which runs on
oil, came to a halt as people
followed orders to remain in their homes
and not go into their offices.
On April 20th, the effects of the
pandemic forced crude oil prices in the
futures market to sink below zero and
into the negative territory for the
first time in history.
Oil prices plunged
into negative territory.
The price settled at get this
negative thirty seven dollars per barrel,
which is down 305 percent, meaning people
would pay you today to take
their oil off their hands.
West Texas Intermediate crude futures
fell into negative territory.
It really shocked the global economy.
This was an event that was
unprecedented and before it happened.
People didn't think it was possible.
It doesn't really make sense when you
try to wrap your head around it.
How could you pay somebody to
take oil off your hands?
It's no secret that the U.S.
economy still runs primarily on oil.
It's been America's largest source of
energy since surpassing coal in
1950, with an average of 20
million barrels consumed per day.
It's also an industry that, along with
natural gas, supports more than 10
million jobs nationwide and contributes to
7.6 percent of the GDP.
America does rely on
oil in many ways.
It's about 90 percent of the
energy that we use in transportation.
And it's more than a third of
the overall energy that we use.
In fact, it's probably going to stay that
way for a lot, a lot longer.
The Energy Information Agency administration
predicts that going out to
2050 is still going to over a third
of the energy that we're going to use.
So how was it possible for oil to
reach a negative value and what does it
mean for the American economy?
To understand what happened, it's important
to know how a futures contract
functions. So the futures market is a way
to bet on the future price of a
certain commodity.
So that can be oil, corn, wheat.
Those are all examples of commodities and
the way that a futures contract
works, is it's tied to a
delivery date in the future.
So you are locking into a contract, both
a buyer and a seller, and you are
agreeing to delivery of that commodity on
a certain date and at a certain
price. So the way the oil market
works, is it's divided between the
physical market, which is the oil itself,
as well as the financial market,
the financial market is made up of
various futures contracts that are tied
to specific grades of crude, as
well as specific delivery dates.
Different types of oil from all across
the world are traded by barrels in
their individual market places.
But two futures contracts serve as
the major benchmark for oil price.
Brent Crude trades oil from the North
Sea in northern Europe, setting the
standard for international
oil prices.
While the West Texas Intermediate, or WTI,
trades a specific grade of oil
traded in Cushing, Oklahoma, that serves
as a domestic benchmark for oil
prices. A refinery might have a contract
with a producer and say, we will
pay you that Brent price or we'll
pay you the Brent price minus the
transportation costs.
Or you know that it's
all subject to negotiation.
And those two are well known.
It's a shorthand, if you will.
And a lot of times other crudes
are priced off of those crudes because
they're well, known the quality is high
and has a long track record.
Similar to most treated commodities, oil prices
rely heavily on how much of
it is available on the market.
In other words, supply and demand.
Oil like like just about anything else
in the world is determined that
prices are determined by a willing
buyer and a willing seller.
And so that means that as demand
goes up, more people are buying it.
The price will typically go up, supply
stays the same and vice versa.
If supply suddenly increases, then then
typically the price will go down
if the demand stays the same.
The demand is determined by how much oil
is needed at any given moment due
to its crucial role in the economy.
High demand has often been associated
with a healthy economic growth.
Historically, oil demand has moved with
the economy of a country.
It's been very tightly tied because
almost all transportation comes from
burning oil and a lot of
other industrial processes use oil.
So when the economy is humming
along strongly, the demand goes up.
And when you have a
recession, the demand goes down.
On the other hand, supply is usually
determined by the producers who have
control over its output.
Historically, the Organization of
Petroleum Exporting Countries, otherwise
known as OPEC, has played a
crucial role in determining the supply.
OPEC currently has 13 member
countries, including Iran, Iraq, Kuwait,
Saudi Arabia and Venezuela
as founding members.
However, a lot has changed in
recent years as the U.S.
surpassed both Russia and Saudi Arabia
to become the world's largest crude
oil producer since 2018.
Thanks to the rise in
production from American shale fields.
Essentially these countries and OPEC,
everyone is competing for market
share. Everyone wants to produce more
for their country, but also the
optionality to export it to another
country and especially growth regions
such as China, Asia.
Being an investor or a producer in the
oil industry means keeping an eye on
this fine balance between supply and
demand, as well as the geopolitical
events that could
threaten the industry.
Never forget about geopolitics and the impact
it can have on the oil price,
because that can be that X factor of why
oil may have a big premium or a
big discount to fundamentals that
you see supply and demand.
It's because geopolitics introduces
other risk factors.
A historic drop occurred on
April 20th, 2020, with U.S.
oil prices on WTI dropped
by almost 300 percent.
Trading around negative 37 dollars.
What happened with oil in terms of
the negative pricing in April with the
futures contracts was
rather unprecedented.
We have seen negative prices before.
For example, last year we were
talking about negative natural gas prices
and Waha in April 2019.
But that's more due to processing or
field issues, not what is happened
specifically this time with the COVID
19 and in the price war.
Oil prices had been under pressure
since January as China battled the
spread of COVID 19.
When the pandemic finally reached the rest
of the world, demand took a
devastating hit.
People started talking about the demand going
down 2 or 3 percent instead
of growing by 1 or 2 percent,
as was had previously been expected.
But then by the time it got to
the United States and all over Western
Europe, the forecasts
were very different.
And at the trough, we probably saw
demand in April bottom out, down 30
percent. So we've never seen anything like
this, certainly in the last 40
years since world oil
markets have developed.
To make matters worse, a price war
erupted between Saudi Arabia and Russia
in early March after OPEC and its
allies failed to reach an agreement on
deeper supply cuts.
Oil saw its worst trading
day in 20, 29 years.
Yesterday, both WTI crude and Brent crude
lost nearly a quarter of their
value, and the S&P energy sector ended the
day 50 percent off its 52 week
closing high. Saudi Arabia launched a
price war against other key
producers. As supply remains steady
while demand struck record breaking
lows. The petroleum industry quickly began
running out of storage space to
put their oil. Cushing plays a very big
role as one of the main hubs of
that commercial storage.
And Cushing at the time of the
negative contract was around 70, 70
percent full, and what was
left was perhaps already committed.
So that was a huge issue because Cushing
plays one of the main roles in
pricing the WTI contracts.
As the delivery date
for WTI grew near.
And investors had nowhere
to put the oil.
They soon began a massive sell
off, prompting an unprecedented crash into
the negative territory.
WTI special in a way, because it's
so tightly connected to physical oil.
And so if you're holding a contract
for WTI, you're expected to take
possession of oil. What was happening was
the buyers who had bought a
futures contract, which meant they had
responsibility to take delivery of
the oil, recognized that that storage was
filling up and they had no place
to put the oil and
they didn't want the oil.
And so they wanted to
get out of the contract.
Usually they can get out of the
contract by getting somebody else to take
the oil instead at a positive price.
Cause oil's a valuable commodity.
But there was nobody who wanted to
take that oil, particularly because it
was located in an area that was
producing way more oil than they needed.
And the pipelines to move oil out
of that area were completely full.
The historic drop quickly sent
shockwaves through the U.S.
financial market. The Dow plunged by
over 1,200 points over the following
two days, and brokerage firms
like interactive brokers reported taking
109 million dollar hit to
cover its customers losses.
It was kind of like what happened in
2000 where we we're wondering if the
computers could roll over.
Some of the traders computers
couldn't even handle the negative.
They weren't set up for a negative.
So you can imagine the disarray and
the surprise, you know, that some
traders faced the next morning when they
looked at their margin calls or
what they owed based on
the severity of this drop.
However, experts point out that although
the event was unexpected, there
was no need to panic.
It was not unforeseen.
The exchange itself saw it as
a possibility ahead of time.
They actually discussed what to do if
that were to happen, reprogram their
software and so forth.
And at least one major media outlet reported
on it a week ahead of time
before it happened. Also, some other
products have gone negative in the
past. Things like natural gas.
So I think it's important to put
it in perspective that while this had
never happened with oil before, it
was just on one particular instrument.
The WTI was just for one day and
it was seen as at least a remote
possibility ahead of time
that it happened.
It was very few contracts.
There was very little trading at those
prices and the price very quickly
rebounded into positive territory.
Now prices are very low.
So that is a reflection of
the fact that demand dropped tremendously
and supply was not able
to drop this quickly.
Since then, we have seen actually production
in that area of the United
States drop drastically and start to catch
up with the drop in demand.
The price of oil has steadily recovered
since the event, jumping by nearly
90 percent in May and registering the
best month on record for West Texas
Intermediate. However, the petroleum industry
is still reeling from the
effects of the pandemic.
Major companies like Chevron, Exxon and
Conoco Phillips have all announced
deep production cuts.
And Whiting Petroleum, once a large player
in the oil industry, became the
first major company to
declare bankruptcy in April.
The impact will likely be
more severe for the U.S.
shale industry that is often in heavy
debt due to its high production
costs. We might not see
the price go negative.
I think that was just a quirky event,
but we could see the price drop down
into the teens or 10 dollars, and then
we would see a real devastation of
the shale industry. As it is, we're
still likely to see a pretty big
devastation. A lot of the shale companies
are going to go bankrupt because
they've been betting on prices being
50 or 60 dollars a barrel.
And that would take a really massive
rebound in the economy to happen.
Just like any other sectors
of the American economy.
The health and the success of the
petroleum industry now rests on how
quickly and safely the U.S.
can reopen for business.
We know that when the economy gets back
up and running and people feel safe
and are able to get back to normal
life, they'll be using oil and gas
products again. And our industry will
be very happy to provide them.
