Last week we wrote about the unprecedented cut to oil production following a deal between most of the world’s major oil-producing states at the behest of the United States. Despite the size of the reduction (10 million barrels per day), we noted the market’s somewhat subdued reaction. We explained that in the background, rising stockpiles could soon exceed levels of storage capacity, keeping prices low for longer.
However, we did not anticipate that these capacity issues would be so acute as to send one of the two leading global oil-price benchmarks, West Texas Intermediate (WTI), into negative territory within two days of publication. On Tuesday, a multitude of headlines exclaimed ‘Oil Price Turns Negative for the First Time’.
While these statements are technically correct, they miss out on several nuances underlying the headline. These dynamics mandate closer examination to provide a complete picture of what happened. Before that we will explain WTI and oil futures contracts briefly.
West Texas Intermediate and Brent Crude
West Texas Intermediate is a grade of crude oil and, along with Brent Crude, is one of the two most popular grades traded on oil markets. WTI is the primary pricing benchmark for the US, with Brent providing the same function for the rest of the world.
Both grades are easily refined into oil derived products containing little sulphur and are said to be ‘sweet and light’.
However, extraction, location and transportation of both grades differ. WTI oil is extracted from oil wells across the US and sent overland via pipelines to the main US storage facility at Cushing, Oklahoma. Meanwhile, Brent Crude refers to oil extracted from four oilfields in the North Sea, with tankers providing transportation.
Oil Futures Contract
Oil futures are derivatives contracts that allow traders to determine and lock in the price of oil months in advance of delivery and link to one of the two main benchmarks examined above. They are an effective means of connecting producers and buyers to deliver specific amounts of physical oil at an agreed location for an agreed price.
Oil futures allow oil producers and refiners to manage and hedge against price moves to fit their business needs and for investors to profit from changes in the oil price. Essentially, if investors believe crude oil prices will rise in the future, they will purchase crude oil futures contracts now. Conversely, if investors have a bearish outlook, they will sell their positions.
What happened?
Graph 1 below, displays the dollar value of a barrel of oil using both the WTI and Brent Crude benchmarks, represented by the blue and orange lines respectively. The dates selected reflect the days preceding the expiry date of the WTI May futures contract on the 21st of April.
As shown below, the prices of both WTI and Brent were broadly in line at around $20 per barrel. However, as time progressed on Monday, the benchmarks began to diverge, with WTI falling by half to about $10 per barrel. What happened next was unprecedented.
As shown in Graph 1, the May WTI continued to fall during US trading, entering negative territory. By market close, the value of the WTI contract had dropped by $56 per barrel to – $37.63, a whopping drop of 306%.
The fall into negative territory essentially enabled a buyer of a May WTI contract to receive payment for purchasing a contract.
Graph 1: West Texas Intermediate and Brent Crude Prices
Source: Bloomberg, data as of 23rd April 2020
Why?
As we explained last week, the world has been experiencing a glut of oil, due in no small part to increased US oil production over the last decade. The deflationary pressure on oil prices has been exacerbated recently by demand destruction caused by the spread of COVID-19
More recently, Saudi Arabia and Russia’s battle for market share created supply spikes during the weakest period of oil in demand for decades. The overall effect is a daily gulf between demand and supply of 29 million barrels of oil per day in April, with the proposed OPEC + supply cut not due to take effect until next month.
The present glut led to rising inventories, placing strain upon global storage capacity. The capacity problem is especially acute for WTI futures contracts for one key reason.
Unlike Brent Crude futures contracts which are settled in cash, WTI futures contracts are settled physically on expiry, requiring a holder of a contract to take physical delivery of the oil.
Ordinarily WTI contracts settle without any problems. However, as the expiration date for May WTI futures contracts came into view on Monday, oil traders struggled to find buyers because of lower global demand. If traders cannot sell their contracts, they must take physical delivery of the underlying oil at Cushing, Oklahoma as per the contracts’ terms. However, nearly all available capacity at Cushing is already occupied and, on current supply trends, any spare capacity will disappear by the first week of May.
Essentially, esoteric oil derivatives contracts have collided with the physical realities of the underlying oil market. In other words, there is too much oil and not enough storage.
Outlook and Next Steps
At the time of writing, WTI futures prices for June seem to be holding steady at around $18 per barrel and futures dated for later months are still buoyant. Whether this trend continues is unclear at present. It is possible that the stresses exhibited this week could be repeated in May.
However, the Trump administration has been explicit in its desire to provide support to the US oil industry. Over recent weeks, President Trump has signalled his intentions to bolster US producers by filling the US Strategic Petroleum Reserve (SPR).
Logistical and political hurdles exist before WTI oil makes its way to SPR facilities on the Gulf coast. But, if surmounted the net effect would be the removal of up to 77 million barrels of WTI intermediate, alleviating some of the capacity crunch at Cushing and buttress prices.
Additionally, with oil prices subdued an opportunity exists for the US government to earn a significant return for its trouble when prices bounce back.
Conclusion
Opening the US Strategic Petroleum Reserve could represent an effective solution for the reasons given above, at least over the short-term. However, the unique capacity problems for WTI oil can only truly be solved by a resurgence in global oil demand or by constructing new infrastructure.
For consumers and businesses with input costs based on oil, low oil prices are good news. Inventories will not disappear over-night, which will keep a lid on prices and bolster economic activity when economies finally emerge from COVID-19 induced lockdowns.
With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.
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