On 20 April 2020 the oil price made history. The US benchmark oil contract – known as West Texas Intermediate (WTI) – ended the day at minus $37/barrel, entering negative territory for the first time. So much oil was available, with so little demand for it from a global economy in lockdown, and barely any space left to store it, that producers and traders had to pay buyers to take it off their hands. Having seen negative nominal interest rates, we have now also seen a negative price for a real commodity: two ‘impossible’ events taking place in a relatively short time.
How could this happen?
Lockdown measures put in place to contain the spread of COVID-19 represent an unprecedented shock to global oil demand. The International Energy Agency (IEA) forecasts that the drop in global demand in April will be as much as 29 million barrels/day year-on-year (around 30% of demand), followed by another significant year-on-year fall of 26 million barrels/day in May. The world has returned to oil demand levels last seen in the 1990s.
As a result of this unprecedented fall in demand, oil-storage facilities in the US have filled-up quickly, rising at an average of 16 million barrels per week over the last three weeks. The oil glut is also evident in Cushing (Oklahoma), a major trading hub for US crude oil to which the oil that trades on the US futures market is delivered. With total oil storage capacity of 80 million barrels, Cushing now has only 20 million barrels of free storage left, which is now fully booked and likely to be completely utilised by the end of May.
WTI futures contracts are settled by physical delivery of crude oil each month, giving a real-world link to one of the world’s most heavily traded derivatives. Under normal circumstances, there is a reconciliation between physical delivery and futures prices close to expiry. But on 20 April, as the WTI headed towards its expiry date for May delivery, the lack of available storage capacity in Cushing caused a wave of panic among traders holding derivative contracts, who found themselves unable to resell them, and with no storage booked to get the crude delivered to the delivery point specified in the contract: Cushing. It was this peculiar situation that sent the oil price negative, dropping from the opening level of $18/barrel, to the historic minus $37.
When will oil markets recover?
The oil price crash thus resulted from a series of coincidences in the US oil market, and does not necessarily represent future market conditions. While the WTI May contract sank to minus $37/barrel, July WTI continued to trade at about $20, and October WTI traded at about $30. However, a situation similar to 20 April might be repeated as the June contract expires on 19 May (this contract is already under severe pressure in the market), and even after if oil demand does not recover.
Demand is indeed the main cause of, and the ultimate solution to, this unprecedented situation. What oil markets are experiencing is a physical stress arising from extraordinary low demand and limited storage capacity. This will continue to reverberate unless global demand picks up again.
To be clear, this problem goes beyond the US and concerns the whole world. Free global storage capacity is currently estimated at 500-600 million barrels, which could be used up by June. This is the reason why, after the WTI slump, Brent (the leading global oil price benchmark, covering two-thirds of internationally traded crude oil) also experienced renewed downward pressure, before rallying after a President Trump tweet threatening military action against Iranian gunboats in the Gulf.
To try to prevent such a scenario, the world’s top oil producers in the OPEC+ alliance on 12 April pulled off a historic deal to cut global oil production by nearly 10%, starting on 1 May This ended an oil price war triggered just a month before by Saudi Arabia, in response to Russia’s refusal to jointly cut oil production to balance the effects of the pandemic on demand. However, the most recent developments have clearly shown that the extent of the unbalancing of oil markets is well beyond the reach of this supply-cut agreement.
Companies including ConocoPhillips and Continental Resources have already said they will shut down 25-30% of their oil production, and all other US producers will be forced to take similar measures. US oil production stood at 13 million barrels/day in February, and is expected by IHS Markit to drop by 2.9 million barrels/day by the end of the year as a result of the current situation. But abrupt shut-downs partially damage oil fields, and restarting them once demand returns will take longer and will in any case limit their capacity. Capital expenditure by exploration and production companies will also substantially drop this year. First estimates point to a 40% spending reduction in the US and a 20% reduction globally compared to 2019. All this could cause significant imbalances in the medium term. While low oil prices are good news for consumers in the short term, they might not necessarily be in the medium term, as prices could spike. Furthermore, as the IEA suggests, low prices could undermine the ability of the oil industry to develop some of the technologies needed for clean-energy transitions around the world.
To prevent enduring damage to the US oil industry, President Trump might seek to pursue other measures, such as bailing out American producers, introducing tariffs on foreign oil imports, freeing-up storage capacity or even buying oil that producers leave in the ground until prices recover. Meanwhile, the OPEC+ alliance might try to scale-up its production-cut agreement in a desperate attempt to contribute to a rebalancing of the market.
All these measures might alleviate the damage to US and global oil producers, but it is reasonable to assume that this oil crisis will ultimately be solved only by a pick-up in global oil demand, once lockdowns are lifted and the economy is restarted. That is, COVID-19 is leading to a collapse of oil markets, and they will only be able to return to normal (or to a ‘new normal’, since damage might be long-lasting) once the virus is defeated.