On Monday, just a day before the May contract for West Texas Intermediate crude was due to expire, US oil prices plunged into negative territory for the first time in history. The move broke bank risk desks, as traditional options models assumed zero was as low as prices could go. It also broke exchange traded funds (ETFs) that invest in oil and no doubt a few hedge funds. It was seen by many as nothing more than a rollover issue, as the May contract had become so illiquid, and trading desks had long abandoned it for June. But as soon as the June contract became the ‘front month’ it too tumbled and Brent, the international benchmark, has just slumped to a 21-year low. There is trouble in the oil market that goes well beyond the technical aspects of futures trading.
There has been no let-up for crude prices. Less than a week after Opec secured an historic agreement to reduce global output with the backing of its key ally Russia and the G20, prices of US crude fell below zero as demand forecasts collapsed and the true extent of the coronavirus impact was laid bare. The pressure on the front month contract intensified and May WTI plunged to -$40 at one point as traders were forced to exit positions before the expiry. This was largely because of a lack of storage capacity combined with virtually no physical demand due to the Covid-19 lockdown.
Nymex WTI, unlike Brent which is cash-settled, is a physical contract. If you hold the contract at expiration you need to take delivery of the barrels. Under normal market functioning, paper traders are rolling their positions into the future months well ahead of time without any fuss. But this time the usual physical buyers didn’t want the oil because they have nowhere to sell it and nowhere to store it. This created severe dislocation and a resultant implosion in the May WTI contract as paper traders found they had to offload positions without any liquidity or a bid in the market. It was a unique event, but one that reflects how financial markets can become very dysfunctional very quickly when things go bad.
But while future months’ contracts are trading higher and are smoother, there are signs that the carnage is not over yet. Moreover, it looks as though Brent crude, the international benchmark, is also feeling the heat. Planned production cuts by Opec and its allies cannot come soon enough.
Earlier this month Opec and its allies secured the biggest deal in the history of the oil cartel, ending a price war sparked just a few weeks prior in an attempt to staunch a rout in crude oil prices which threatened to do irreversible damage to the industry. The question is, with prices once again sinking, will it work, or was it too little, too late?
In the days after the Opec++ deal was announced, data revealed China’s GDP fell by 6.8 per cent in Q1, contracting for the first time since records began in 1992 and likely since at least 1976, while data showed that a decade’s worth of US jobs growth has been wiped out in a month. In the same week, Opec itself predicted oil demand would slump to the lowest level in 30 years, while the Paris-based International Energy Agency (IEA) said consumption of oil in April would fall by almost 30m barrels per day (bpd), equivalent to a third of normal demand.
Oil markets are in the middle of a twin supply and demand shock. Back in early March, Opec and its ally Russia failed to agree on an extension of production cuts equivalent to 1.5m bpd. The true extent of the demand shock was not fully known at the time, but oil prices had tumbled in lockstep with equity markets due to the virus spreading to Europe and the onset of government-enforced lockdowns. Moreover, we’ve been dealing with a long-term glut in oil markets that Opec has been fighting for well over three years as US output – driven by the shale sector – surged to an all-time high. Even before the coronavirus drove a horse and cart through the market, fears were mounting that Opec had lost its ability to control prices and could do nothing to fight rising output in the US, Norway and Brazil, among others.
Demand was also a worry as the world economy slowed. Global trade was in sharp decline as a result of the US-China trade war, while we could find other reasons such as new rules forcing the marine shipping sector to lower sulphur emissions, raising costs, lowering demand. Or the fact Chinese GDP growth was heading into a slower long-term path. Even before the coronavirus hit, oil demand growth in China was forecast to be half what it was last year.
Set against this, the shaky alliance of Saudi Arabia and Russia, which had underpinned the Opec+ alliance for three years, was starting to crack. By early March, with fears about Covid-19 starting to ramp up quite considerably and equity markets in free fall, the entente fell apart. Russia wouldn’t back further cuts; Saudi Arabia decided to go its own way and opened the spigots, committing to raising production to maximum levels and within hours offering steep discounts on its exports. The plan, if there was one, looked like it was to crash the market and send higher cost producers such as the US shale industry out of business for good. Prices plunged.
As I noted in my daily Market Outlook column at the time, the combination of a massive supply surge from Opec and a complete collapse in demand would create the most bearish conditions imaginable, likely to send WTI under $20 a barrel 20 (how far they would go lower caught many, but not all, by surprise) as stockpiles would inexorably build higher and higher. I also commented that “the severity of the drop in crude after months of weakness could force the erstwhile allies back to the table”. Unlike other moments when oil prices have collapsed, lower prices cannot this time boost demand as people are not able to drive or fly more.
And so barely a month later, under heavy pressure from the White House to do something, we had Opec and Russia committing to reduce production for two years with an initial shock cut of 9.7m bpd in the first two months. Saudi energy minister Abdulaziz Bin Salman says as much as 19.5m bpd will come out of the market initially, or about a fifth of global supply, although this involves using some creative accounting, factoring in reductions forced on producers by the drop in prices and adding in some buying into strategic reserves by various nations.
“Such numbers significantly overstate the level of voluntary cuts, in our view, as they include overly optimistic assumptions on market driven declines as well as on government crude purchases for strategic reserves,” analysts at Goldman Sachs said in a report in which they argued that the level of government purchases and voluntary cuts are “too little, too late”.
The IEA says global oil supply will decline by a record 12m bpd in May a result of the Opec++ agreement. It notes that because output in April was high, the effective cut is 10.7m bpd. Additional reductions are set to come from other countries, with the US and Canada seeing the largest declines. Total non-Opec output falls could reach 5.2m bpd in the fourth quarter of 2020, and for the year as a whole output may be down 2.3m bpd from 2019 levels.
Indeed, output in North America is already collapsing. The US Energy Information Administration (EIA) sees output down 366,000 bpd in April to 8.71m bpd and a further drop in May to 8.53m bpd. It wasn’t long ago US output was around 13m bpd.
Baker Hughes reports that the number of active rigs in the US declined for five straight weeks to 529, down from over 1,000 a year ago. In Canada, the number of active rigs has declined to just 30 from as many as 240 in February. Bank of America says the deal by Opec will stem the decline in the US – just 1.8m bpd being lost versus a 3.5m decline without the deal.
So, if between 10 and 20 per cent of global supply is being turned off, why are prices not rising? The answer lies in the demand destruction going on and, more crucially for speculators, uncertainty about the future path of global economic growth. Meanwhile, futures markets show traders do think prices will rise in a few months.
Impact of coronavirus – demand falling off a cliff
The chief problem is that demand is falling faster than the reduction in supply.
Opec says global oil demand in the second quarter will be around 86m bpd, down by 12m bpd year on year. Demand for Opec crude will fall by a third to 19.73m bpd, the cartel said in its latest monthly report, which would be the weakest call on its oil since 1989. Rystad Energy estimates that demand will fall by 27 per cent to 72.5m bpd in April, and 90.3m bpd for the full year, or 9.6 per cent year on year.
The IEA also said last week that oil demand is expected to fall by a record 9.3 bpd year on year in 2020 as lockdown measures bring mobility almost to a halt. Demand in April is forecast to fall by 29m bpd from a year ago, a level last seen in 1995. The demand shock will linger beyond April: demand in the second quarter is expected to be 23.1m bpd lower than a year ago. And recovery will be “gradual”, with December demand set to be down 2.7m bpd year on year.
As demand dries up, inventories build fast
The IEA thinks global petroleum inventories will increase at an average rate of 11.4m bpd in the second quarter, which would be the largest rate of inventory increases since the administration started records. These very large stock builds will keep downward pressure on crude oil prices for several months at least.
The IEA estimates that the implied stock build-up of 12m bpd in the first half of the year may “overwhelm the logistics of the oil industry – ships, pipelines and storage tanks – in the coming weeks”. Available capacity could be “saturated” by the middle of the year.
The information from the industry is that storage vessels are in short supply and becoming more expensive. Chartering costs for Very Large Crude Carriers have more than doubled since February. Shipping sources estimate traders are storing at least 160m barrels of on tankers at sea, versus the 80m seen on 1 April. Things are getting desperate.
Gasoline demand in the US has collapsed. Around one tenth of all global demand – roughly equivalent to 10m bpd – comes from vehicle use in the US. As demand has fallen, stockpiles are rising.
And as stockpiles rise, the pressure on prices increases. The real worry is storage. Prices have fallen low enough to knock out a good portion of supply, while Opec does the heavy lifting. Nonetheless, if storage capacity runs out then you won’t be able to give the stuff away – as prices in negative territory demonstrate. US crude storage is expected to be full by the end of May, while Energy Intelligence reckons the effective global capacity will be full by June. And we are not just talking about crude storage, but the capacity for refined products. If this fills up then refiners will have to cut back, too. Rystad Energy noted in a recent report: “There is not enough storage to absorb this unprecedented oversupply, so something has to yield: Refineries first, then production from Opec+ and finally other producers, as the oil price falls below the marginal cost of production.”
Oil is now in a ‘super contango’ market, whereby futures prices are steepening out along the curve. The spread between the front month and future month deliveries for WTI had widened to an 11-year high even before the Monday meltdown in the May contract. Brent is less in contango than WTI, the US benchmark, as it has a wider global market and is not subject to the same kind of storage constraints.
“The term structure of all crude benchmarks moved to a super contango in March, as massive oil demand destruction, significant refinery cuts and rising global oil supply were expected to create a large surplus in the oil market,” Opec said in its latest monthly report. “The market surplus was expected to reach around 15m bpd in 2Q20, pushing prompt prices to decline much lower compared with longer-dated contracts.”
The good news if you are an oil bull is that the massive contango is a reflection that traders expect the market to sort itself out, and gradually rebalance as supply comes off and demand comes back. In the meantime, the front month contracts are getting whacked as we approach ‘tank-tops’. Indeed, the bad news is that if this super contango market persists we may see further implosions like we saw in the May contract as we approach settlement as traders will be caught the wrong side of the expiry with nowhere to put the oil. If zero is obviously way too low, future month prices look a tad high, meaning holding oil positions for duration will be tough. Oil ETFs are unloading near months for back months for this reason.
Will production cuts work?
Just as the contango structure in the market indicates, the answer is probably not yet, but there is hope for the future. “The measures announced by Opec+ and the G20 countries won’t rebalance the market immediately. But by lowering the peak of the supply overhang and flattening the curve of the build-up in stocks, they help a complex system absorb the worst of this crisis,” the IEA says. The EIA forecasts Brent crude oil to average $23 a barrel in the second quarter of 2020, but that it will pick up to $46 a barrel in 2021.
Beyond just the voluntary cuts themselves, there are other factors at work. First, countries such as China, India, South Korea and the US are making strategic petroleum reserve (SPR) purchases, or they are allowing storage to be used by industry. Whether this helps much is up for debate. Goldman Sachs analysts write: “We do not view SPR purchases as changing our supply-demand balance since we already assume directed purchases and still estimate that combined commercial and government storage fill capacity would become saturated in April.” This would require around 4m bpd of production shut-ins even before the Opec++ deal takes effect.
Secondly, the low price is forcing closures. Non-Opec output may fall by around 3.5m bpd in the coming months due to the impact of lower prices, according to estimates from the IEA, which adds: “The loss of this supply combined with the Opec+ cuts will shift the market into a deficit in the second half of 2020, ensuring an end to the build-up of stocks and a return to more normal market conditions.”
The US shale sector was already facing a wall of debt maturing, and bankruptcies were rising before this latest crisis. We don’t know exactly how much damage will be done to the sector, but it will be carnage without the kind of intervention in the oil industry that we see elsewhere; for example, the way central banks have intervened in bond markets.
The market is trying to do its job by forcing prices to a point where supply catches up with demand. However, unlike other times when prices drop and you see demand respond to the upside, the nature of economic lockdown means there is just no demand to take advantage of weaker pricing.
Demand rebound is key
In the short term, the production cuts won’t really boost prices but they may prevent a total collapse. The deal should help slow the oversupply and ultimately reverse it, in tandem with the reductions forced on producers. But in the longer term the key is the demand side.
China – which is the key marginal buyer as it is the largest importer and fastest growing market for crude – is getting back to business, but its GDP fell by an unprecedented 6.8 per cent in the first quarter, reversing about 40 years of steady expansion. China will bounce back, but demand destruction can be very hard to recover. Some will be permanent.
A lot will depend on how quickly we see the lockdowns in the US and Europe lifted, at least in the medium term. At the current rate, we think the world’s major economies will be lifting restrictions on movement and travel in May, but only tentatively. In particular, we will need to see the US economy moving again by the summer driving season.
But will demand recover as swiftly as hoped, or as fully? For example, the IEA reckons jet fuel and kerosene demand will decline by about a quarter this year, or more than 2.1m bpd from the 8m bpd average. But according to the consultancy Rystad Energy, it will take years for jet fuel demand to fully recover.
Indeed, there are two bigger topics to consider: the long-term impact of coronavirus on people, their behaviour and the economy; and the structural shift in energy markets being forced by government.
This crisis facing the oil industry comes at a tipping point in the structural shift away from hydrocarbons – we have the absurdity of BP (BP.) aspiring to be carbon neutral. And there is growing speculation that the lockdowns will result in changes in behaviour that we won’t fully understand for many years. Not least, sentiment could be so badly rocked by the economic damage that it may take years to recover the lost GDP.
The problem is countries such as Saudi Arabia and companies such as BP, for all their green ambitions, require highish prices in order to wean themselves off their crude dependency. To make investments in alternative energy and other projects they require the cash flow from selling oil. It’s oil that will pay for the shift from oil.
The demand destruction may also be permanent. Oil demand in the US already peaked years ago, in 2005, and globally we are seeing governments take extraordinary steps, egged on by the climate lobby, to move away from hydrocarbons. Petrol and diesel vehicles will be anachronisms in a few years’ time as electric vehicles become all that is allowed. As I discussed earlier this year when we looked at Tesla (US:TSLA), the electric vehicle (EV) market will be the only show in town. The British government’s decision to ban all petrol and diesel – including hybrid – new car sales by 2035 illustrates the way the wind is blowing.
In the meantime, though, oil prices could well spike. There are different arguments you can make about vehicle use and demand for petrol and diesel in the wake of Covid-19. While EV demand will rise and it will replace the internal combustion engine, we’re at least a decade away from that happening. In the meantime, social distancing measures and – one can speculate – a new way of looking at the world will mean the automobile stages a fight back in its long-running battle against public transport. On the other side of the coin, you can make strong arguments in favour of less travel, long-term economic malaise and so on that will dampen demand for the foreseeable future. I would tend to think both are true, and fundamentally demand growth will trend lower.
And so, we come back to supply. Lower – or even negative – prices will knock higher-cost producers out of action, significantly reduce capital expenditure (capex) and lead to abandoned assets. This creates the perfect environment for crude prices to surge once the demand shock is over and the tanks start to empty.
In the longer term, it should be noted that turning off production is not like just closing the cold tap. In many fields, shut-ins could become permanent as it would require significant capital expenditure to reopen. As the world tries to distance itself from hydrocarbons, it may not make economic sense to reopen, particularly if demand is not recovering fully anyway. Oil research company JBC Energy warns that producers could drop out “en masse”. In the meantime this creates more pressure on prices as producers avoid dialling back production.
So, while the immediate outlook for oil seems pretty bleak, by 2021-22 we may well see a significant bounce back, as a result of lost assets, voluntary cuts and oil companies trimming their capex. “The ongoing violent market rebalancing is increasingly likely to be followed by a sharp rebound in oil prices once demand starts to recover,” says the team at Goldman Sachs. As a result of the catastrophic falls in oil prices, we may just start to see the pieces assemble for oil markets to rebalance, but it could be a brutal few weeks and months ahead.