Six years after a monumental bust, the energy industry is grappling with a once-in-a-generation downturn. Crude oil is facing a heavy bombardment of developments that sent the futures market crashing to its lowest level in more than two decades, proving correct the analysts’ earlier forecasts of prices sliding to the low teens. Could prices slip into subzero territory next? If everything remains the same – and perhaps worsen – the economics of production might turn into producers paying companies to dispose of the barrels they extract from the ground.
A Crude Awakening
Earlier this month, the Organization of the Petroleum Exporting Countries (OPEC) and its oil-rich allies agreed to a historic production cut of 9.7 million barrels per day (bpd). Although industry observers were praying to the black gold deities to reduce output by 15 to 20 million bpd, West Texas Intermediate (WTI) and Brent still recovered to around $29. However, the pact spawned only a temporary relief from the devastating realities the sector faces, erasing any modicum of gains from the Middle East powwow.
On April 20, WTI May futures cratered 36% to below $12 a barrel, while June futures plunged 11% to around $22. Brent, the international benchmark for oil prices, also was battered and beaten: June contracts plummeted more than 6% to roughly $26. The hemorrhaging was historical, bringing the cost for a barrel of Texas tea to its lowest level since 1999.
A futures contract is an agreement between parties to buy or sell a commodity or financial instrument at a specified date at an agreed-upon price. One of the reasons the May contract suffered a steeper drop than June’s was because the front-month generally converges with spot prices closer to expiration.
What the Frack?
So, what the heck is happening in the energy industry? It is a case of good old supply and demand.
Global crude markets are awash in oil. For the last several years, the United States has transformed into an energy king thanks to the shale revolution hatched by the process of hydraulic fracturing – better known as fracking. As a result, it has pumped out immense levels of crude since 2016. Despite their production freezes, OPEC countries and partners also have unleashed large volumes onto the international marketplace. In the kingdom’s falling out with the 15-member cartel and Russia, Saudi Arabia cranked up production and triggered a tsunami of cheap oil.
While this would send prices 10% to 15% lower in any regular bull market, the covidepression sparked a crash in global demand. With tens of millions of consumers under house arrest and economies at a standstill, there is a paucity of need for bubblin’ crude – businesses are closed, and motorists are parked at home. The only noteworthy customer may be the government as officials in the United States, China, and South Korea attempt to take advantage of the 21-year low and add to reserves.
In its April Oil Market Report, the International Energy Agency (IEA) projects a decline in demand of more than nine million bpd, a 25-year low, until the summer. Fatih Birol, head of the Paris-based IEA, was blunt in the group’s assessment: “We may see it was the worst year in the history of global oil markets.” The organization does think there could be a recovery in the second half of the year, but a return to normalcy may be incremental.
The industry is being forced to adapt. American companies are decreasing capital expenditures, European firms are cutting budgets, and Middle Eastern titans are beginning to adhere to the provisions of the deal. Is it enough? Well, consider a few things. Global oil storage is exceeding 70% and might approach operating max. Cushing, the primary American storage hub, has reported stockpiles surging 48% since the end of February. Floating storage – oil held at sea without a booked destination – is nearing full capacity. Shipping rates for Very Large Crude Carriers (VLCCs) has spiked about 700% in one month to $175,000 per day. There is even talk of producers renting federal storage space.
Zero or Negative?
In recent weeks, there has been a lot of speculation that the leading benchmarks could tumble to $0 or even into negatives. This may be true for distressed crudes, such as Western Canadian crude from the oil sands development, but it is unlikely to be the case for WTI or Brent, say Goldman Sachs oil analysts.
They wrote in a March 30 report:
“Waterborne crudes like Brent will be far more insulated, staying near cash costs of $20/bbl with temporary spikes below. Shut-ins will not be based upon where wells sit on the cost curve but rather on logistics and access. High-cost waterborne crude oil that can reach a ship (storage we have historically never run out of) are better positioned than landlocked pipeline crude oil sitting behind thousands of miles of pipe, like the crude oils in the U.S., Russia and Canada.”
But if the doomsday prognostications are accurate, what happens if oil slides to -$3? For one thing, you should not anticipate a credit to your Visa or MasterCard at the local gasoline station. You are not going to be paid to pump gas into your vehicle. What would happen, though, is that a producer would pay someone to dispose of a barrel. The U.S. government may even intervene and pay drillers to leave the oil in the ground. Hedge funds also would likely bail out companies.
At first glance, negative prices seem like a steal. On second look, it may cost everyone more in the end.
Fade to Black
Does this spell the end of Big Oil? Commodities are cyclical in nature, especially crude, but people never learn. The peak oil crowd thought the end was near because a barrel of oil was more than $100, and there were doom-and-gloom warnings of supplies running out. A lot of people thought markets were putting Old Yeller to rest in 2014 when prices experienced a correction. Investors may be proving that they know better than armchair analysts because the U.S. Oil Fund exchange-traded fund (ETF) recently enjoyed a record $552 million in inflows, raising the total to $1.6 billion in one week. So, if you had your eye on Exxon Mobil or Suncor Energy, you might be able to scoop up some shares at a steep discount amid the slaughter. Oh, yes, there will be blood.
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Read more from Andrew Moran.
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