By April 21, prices for the benchmark WTI crude were back in the black. But its brief stay in subzero levels raised new questions that were beyond how long and how deep COVID-19 would cut demand. For producers, the negative prices had them worrying briefly about paying buyers to buy their oil, but now they face longer term concerns, such as having to curtail output; shut down producing wells and defer new well openings; put off exploration; and file for bankruptcies or get acquired in a wave of consolidation, according to experts at Wharton and elsewhere.
In late March, when WTI prices fell from the year’s opening at $61 to some $23 a barrel, the Penn Wharton Budget Model (PWBM) estimated that if oil stays at $23 a barrel through the end of 2020, it would eliminate about 0.25% of GDP, and growth in business investment would be 1.9 percentage points lower.
“Historically, cheap oil was great for American manufacturing,” said Kent Smetters, Wharton professor of business economics and public policy and faculty director of PWBM. “In fact, the major recession in the mid-1970s was caused by the OPEC oil embargo. Today, however, oil supports a large production network in the U.S.” In a blog post, Alexander Arnon, a senior analyst at PWBM, shows the close relationship between oil prices and business investments in the U.S.
“The biggest concern may be a lack of capital across all industries – including clean tech – due to a steep recession, and fewer consumers who could afford new vehicles and thus are holding on to their fuel-inefficient older gasoline vehicles longer,” said Arthur van Benthem, Wharton professor business economics and public policy.
Why Oil Crashed
Last week’s negative price shock occurred in the wake of anxiety that had gripped traders and investors over reports that storage capacity was running perilously short at Cushing, Oklahoma, the sole delivery point for WTI crude. The impulse was a rush to sell. “Investors and traders were so desperate not to receive oil that they were willing to pay others to take the barrels instead,” a Wall Street Journal report noted.
The panic over the shortage of storage capacity led to a rush to dump futures contracts, said Charles F. Mason, University of Wyoming professor of petroleum and natural gas economics. “If you enter into a futures contract, then there’s an obligation for the product to change hands at a specified point in time. But you have time to plan for that,” he explained. “What we’ve seen here is that the people who held futures contracts and therefore were obligated to take possession of the crude at a certain point in time had no place to put it because storage capabilities were filling up. Maybe they waited, expecting things to loosen up. They didn’t and then they were very panicky.”
The April 20 price crash “emphasized how much oversupply there is at the current time,” said Wharton finance professor Jeremy Siegel. “It was a terrible misestimate by traders of the storage capabilities in Cushing, Oklahoma,” he added. “Otherwise why would people be buying long contracts?”
The COVID-19 pandemic has battered the oil markets in a way that hasn’t been seen before. “Energy analysts are pretty good at explaining how certain shocks would affect the oil market if they were to happen, but of course they cannot predict when such shocks happen, or with what intensity,” said van Benthem. “COVID is simply outside what even the most far-reaching energy market scenarios had considered.”
“The biggest concern may be lack of capital across all industries.”–Arthur van Benthem
“Given current demand and storage, it seemed likely oil would have to sell for negative,” Smetters said. In a LinkedIn post, he clarified why: “[The] intuition is that future markets expect oil to return to $30+ by November, and so it is cheaper to sell oil for zero or even negative once storage capacity is exhausted than to cap wells now and uncap in November.”
The U.S. crude oil storage capacity is about 91 million barrels, according to the latest report of the U.S. Energy Information Administration. Nearly 80% of that capacity is booked “by smart and generally well-heeled companies that saw this coming,” Tom Kloza, global head of energy analysis at IHS Markit’s Oil Price Information Service told MarketWatch last week. Current oil production is about 90 million barrels per day, but demand is only 75 million barrels per day, the report pointed out.
President Trump had said in early April that he had spoken with leaders of Saudi Arabia and Russia to cut production, and a week later, OPEC and its allies announced cuts of 10 million barrels a day. “What [Trump] did not foresee, but some of the oil market did foresee, is that U.S. output would drop much more precipitously because there simply would be no place to put it in,” Spencer Jakab from The Wall Street Journal said in a video report.
The panic also caused some overreaction by traders and investors. Mason found it “puzzling” that spot prices paralleled futures prices in swinging wildly Monday last week. Unlike with a futures contract, “you enter into a spot trade when you need the stuff,” he said. “It might just be a behavioral thing that people are overreacting – and there definitely was some overreaction.”
Siegel said that wrong calls by automated trading may be the culprit behind last week’s dramatic price fall. “It could have been – and I’m speculating here – that a lot of computers were looking at the spreads between the current [prices] and the [futures] and noting that they were very large, and that historically, you would do well if you buy. A lot of that might have been basically computer buying, not realizing there are special circumstances there that could cause the price to go negative.”
One fallout from that episode could be a greater reliance on Brent as a more reliable benchmark than WTI, said Siegel. (The three benchmarks for crude oil are Brent, which refers to production from the North Sea; WTI for U.S. crude delivered at Cushing, Okla., and Dubai/Oman, for Middle Eastern crude.) “WTI is going to assume less and less importance in the future and more oil buyers will index to Brent, or they will dramatically change the WTI delivery contract,” he said. WTI futures contracts have less flexibility, because they require buyers to take delivery at only Cushing, whereas Brent crude deliveries can be taken at a variety of locations, a Forbes column noted.
A New Normal
In any event, “a new normal” is being defined by the pandemic, said Mason. It appears that the pandemic will pass in China, followed by parts of Europe and then by parts of the U.S., which will lead to a reopening of economies and lifting of some restrictions such as stay-at-home orders, he said. “When they abate, people will get back out in the world,” he added. “The biggest problem for crude markets right now is that just with the sequestering [of people], there’s a lot less driving.” That of course translates into lower demand for gasoline, and therefore for crude oil. “When it does pass, you’ll be back into something that looks a little bit more like the market not that long ago.”
Mason declined to predict what the price of crude would be once the markets gain equilibrium. “But I would be surprised if it was not well above $25 [a barrel],” he said. But that possibility is subject to caveats, Mason noted. The first is the possibility of the energy markets actually having surplus storage capacity. “The reason why I want to hedge my bets is that with so much storage in place – floating storage, oil in tankers, physical stores, oil in storage [facilities] and here and there and everywhere – oil is going to make its way out of the market,” Mason said. “The last time we had a scenario like this was after the prices crashed in late 2014,” he recalled. “Lots of oil in was storage and it depressed markets for a long time. It took several months for all that to work through.” That situation could play out in the current setting as well, he noted.
Another caveat is the impact of “behavioral changes” in how work gets done, said Mason. That would include increased telecommuting, organizations requiring fewer employees to work out of offices, or have their employees come to work on fewer days of the week, staggering work hours and so forth. Those practices would mean offices would need less heating and ventilation, for example, and also reduce rush-hour traffic congestion, he noted. Another wild card is how after the pandemic people take to international or long-haul travel, and the impact on demand from the aviation industry, he added.
“It was a terrible misestimate by traders of the storage capabilities in Cushing, Oklahoma.”–Jeremy Siegel
Oil demand could revive and lift prices if the pandemic passes and economic activity returns to levels that prevailed three or six months ago, said Mason. If such a revival occurs, “then I would be very surprised if crude prices stay below $30. But that could easily be half a year,” he added.
Many in the oil industry worry that the pandemic will continue in the summer months that usually see peak demand. All over the world, people have cut back on business and holiday travel and economic activity has shrunk, dramatically reducing demand for oil.
Cheaper crude will not necessarily translate readily into bounties for consumers. “It is hard to store up oil … unless you have a nice in-ground swimming pool,” said Smetters. “And, just because crude oil is free or even better priced, it still costs money to refine it and distribute it. Gas prices at the pump won’t go to zero even at negative crude prices.”
“The annual summer dip seems small compared to the much bigger question: When will the economy start up again, and will society revert to its old habits, or has the crisis permanently changed the way in which we live and the products we demand?” said van Benthem. “Will videoconferencing be an acceptable business practice even without COVID, or will the planes fill up with conference goers, business people and spring breakers again? Do we enjoy the current reduction in pollution enough to permanently push for more environmental protection?”
Impact on Oil Companies
Oil companies are responding to the uncertainty over demand with a wait-and-watch approach, and holding off on fresh investments. Mason expected most oil companies to “delay expenses or shut down production or push off exploration” to the extent they can. Some companies may not have such flexibility. Those that have overextended themselves with loans that have to be paid off would worry about going bankrupt, he added.
“Those who have a certain amount of flexibility, who have the cash balances, who have built in insurance policies for this sort of thing in terms of the possible financial structuring — there will probably be less activity from them in the next three or six months,” Mason continued. They would “just wait and see, because prices are bound to rise at some point over the course of the next several months.” At that stage, they would come back and resume production, he added. He recalled the CEO of an oil company in Denver telling him a few weeks ago that her company was “basically hunkering down.”
Many oil producers will feel compelled to cap producing oil wells with the prevailing prices, said Siegel. “It’s expensive to cap the wells, so a lot of the wells were kept open and continued to produce,” he said. “And now they have to be capped. When the front end is so low, then it does pay to cap it. They would incur that cost and then sell it in the forward market a year from now where the price is much higher.”
“Given current demand and storage, it seemed likely oil would have to sell for negative.”–Kent Smetters
However, capping wells is not an easy option. “It’s a short-run versus long-run situation,” said Craig Pirrong, University of Houston professor of finance, whose expertise includes the economics of commodity markets. “Capping is a short run strategy, and it’s not practical for most producers. So the medium-to-long term response to continued low demand will be to keep wells open, and see output decline due to depletion, and not replace many of them with new drilling.”
“Capping a well is not like putting the cap back on the ketchup bottle,” said Smetters. “Capping some wells can be cheap. But high-pressure, high-temperature wells are harder to cap and plugging them is more permanent and expensive.”
Several oil companies have already taken decisive steps. Last week, Royal Dutch Shell announced that it has postponed its Jackdaw natural-gas field development in the North Sea. It is expected to delay upstream projects in the North Sea as well, according to an S&P Global Platts report. The company had also last month backed off from an equity investment in a liquefied natural gas project in Lake Charles, Louisiana, citing “current market conditions.” Other oil companies in the Permian Basin such as DiamondBack Energy and Parsley Energy have also announced cuts in production and activity, according to a Fortune report.
The current prices are also far from levels where producers could recoup their costs. The break-even price for crude production varies widely by country, with less than $50 a barrel for Russia and nearly $200 for Iran, which is hamstrung by U.S. sanctions, according to a Financial Times report. The break-even rate of producing shale oil in the Permian Basin in Texas ranges between $40 and $55 a barrel, according to Fortune. “It varies across the U.S. and it varies even at the same place,” said Mason.
Drilling new wells in the current scenario is unlikely because of the high upfront costs they entail, said Mason. But drilled and uncompleted wells could be converted into producing wells at a “low incremental cost,” and those will be the first to come back online when the market recovers, he added.
Consolidation on the Horizon
It is inevitable that there will be some consolidation in the oil industry, with weaker companies getting acquired or closing down. “All the firms that are in trouble are going to go broke,” said Mason. “Somebody has to buy them out. And that somebody could be a medium-sized company, or it could be an oil major. But they will be snapped up because they come with assets. Among other things, they have some other leases or they have direct access to resource deposits. They have human capital in terms of their employee pool. They have some typical capital machinery and other assets that are valuable.” According to Pirrong, “There will certainly be consolidation in and exit from the E&P (oil exploration and production) sector in the U.S. If anything, it will lead to expansion in storage capacity, and [at] the firms that provide it.”
“There will certainly be consolidation in and exit from the E&P (oil exploration and production) sector in the U.S.”–Craig Pirrong
Consolidation is imminent also in the oilfield services industry, said Mason. The big companies in that space such as “the Halliburtons and the Baker Hughes and Schlumbergers of the world” would withstand the upheaval, but the relatively smaller firms for those “could go broke,” he noted. Pirrong added: “Service operators live and die with drilling activity. Absent a rebound in that activity, the outlook for service firms is as bleak or bleaker than that of the E&Ps.”
The oil industry could also face constraints in the supply of talent. “While the low oil prices don’t translate one-for-one to lower gasoline prices, cheaper gas at the pump would also slow down demand for electric vehicles,” said van Benthem. “A prolonged crisis may have long-lasting effects with lay-offs of highly trained employees and a lack of new talent entering the industry,” he added.
What if Oil Falls to Less Than $10?
Meanwhile, U.S. oil prices have continued to decline because of fears over storage capacity. On April 28, the WTI contract for June fell to $10.07 a barrel before rising back up to $11.17. Many analysts worry that prices could fall below $10 a barrel. “If prices settle at $10 for an extended period, it will mean the industry is in deep trouble,” said Pirrong.
“A ‘new normal’ of sub-$10 oil prices would surely kill new investment and exploration activities, and would even force existing producers to shut down,” said van Benthem. “This is already happening.”
However, van Benthem did not foresee prices going below $10 a barrel. “While the negative oil futures prices grab the headlines’ attention, the Brent futures strip does not currently suggest that sub-$10 will be the new normal,” he said. Brent futures for June onwards are above $21 and rising for subsequent months. “The 2022 futures trade around $40 per barrel, suggesting that the market expects oil demand to recover significantly post-COVID.”
The current prices “may just reflect an enormous temporary friction,” said van Benthem. “The market is desperately trying to find storage opportunities for the excess oil that’s still being pumped up, now that there’s no demand for oil with our empty freeways and grounded planes.”
The power of OPEC is also waning over how its members toe the prices to which they agree. “OPEC could in theory raise prices by a lot, but historically, the cartel has only rarely effectively managed to withhold substantial amounts of production,” van Benthem noted. “The sub-$10 world [that some describe] may force them to act more decisively this time. The question is: When will the first OPEC members start defecting once the withholding strategy proves successful? More often than not, defectors cut production less when the oil price rises again, risking the stability of the cartel.”
Changing Geopolitical Equations
The power balance between oil producing countries is getting disrupted, and OPEC and Russia will see their influence diminishing. “It’s kind of the same question that came up in 2015. The answer is kind of the same as it was [then],” said Mason. Back then, WTI prices crashed from $107 in June 2014 to $36 by end-December 2015, under the combined impact of falling demand and rising supply, chiefly from Texan shale oil. “This is not a good time to be a member of an oil cooperative like OPEC. Their days as the big dog are gone.”
“To the extent that power is important, it’s the power to influence the market and change prices. Those days are gone for the big producing countries.” –Charles Mason
The stark reality facing yesteryear’s oil producers is that “there are just too many opportunities to find oil elsewhere,” said Mason, pointing in particular to the tight oil deposits in the Permian Basin. Production in the U.S. has been on a steady climb since 2008 when the first shale oil well was drilled into the Eagle Ford Shale in Cotulla, Texas, and from 2010, when output jumped from the more promising Permian Basin that spans Texas and New Mexico.
The growing U.S. influence in global oil markets ends up negating attempts by other oil producing countries to prop up prices. Mason explains: “If Russia and the Saudis do a deal to restrict output, then it puts upward pressure on prices. And the upward pressure is going to encourage more drilling in the Permian Basin. And lo and behold, there is going to be output that offsets the reduction that the Saudis and the Russians just spent so much time trying to put in place.”
The same pattern is likely to play out now as well, Mason said. “The Saudis and the Russians may persistently have a large-ish market share, but I’d be very surprised if they have much ability to influence price,” he added. “To the extent that power is important, it’s the power to influence the market and change prices. Those days are gone for the big producing countries.”
“[Unlike earlier], when demand was sufficiently tight to generate prices at which U.S. producers could operate profitably, the supply-demand balance has swung radically into imbalance,” Pirrong said. “Assuming that demand comes back, a similar situation will arise. The transition during the rebound is much more difficult to forecast. Insofar as Russia’s predictability is concerned, it suffered a humiliating defeat and now knows that backing off on promises could bring swift retaliation from the Saudis. They will likely think twice before trying that again.”
Russia especially could be hit hard by the price crash, since it exports 70% of its oil production, said Smetters. The drop in oil prices in 2014 “wreaked havoc” on Russia’s economy, but last Monday’s price drop is much larger, he noted. Russia is putting on a brave face. “The pandemonium with futures is absolutely speculative, [and] just a trading issue,” a Bloomberg report quoted Kremlin spokesman Dmitry Peskov as saying after last week’s negative prices on futures contracts. “There’s no need to give this an apocalyptic tinge.”
What Policy Makers Could Do
The options are limited for the Trump administration in responding to the supply glut. “I don’t see how the federal government could do much other than add some supply to the strategic oil reserve,” said Smetters. He noted that as of April 17, the strategic oil reserve held 635 million barrels out of a total capacity of 797 million barrels. “Even ignoring shipping costs, that open reserve equals about two days of total world oil production. With shipping costs, it would take a while to fill. The government can’t force producers to reduce or cap,” he noted.
If some of the changes in terms of reduced travel and remote working do take hold longer term, policy makers may need to step in, according to van Benthem. “I strongly believe that such large structural changes require political leadership and economic incentives, and that places a big responsibility on the shoulders of politicians across the world to spend our COVID stimulus money wisely in a forward-looking way,” he said.
“There is a heated debate about whether the COVID stimulus package should be a political opportunity to pull employment and capital away from polluting industries towards renewable energy, energy efficiency, and other investments that clean up and modernize our economy at the same time,” van Benthem continued. “To put it bluntly, given a limited amount of funds, would you rather keep and grow jobs in solar energy, or subsidize shale oil producers? Do we want to bail out airlines or subsidize jobs in cleaner services industries to prevent mass unemployment?”
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