April 22, 2020: Oil Prices and Storage Capacity
Simply put, we have more oil than places to put it. Supply and Demand.
The standalone headline touting the “price of oil is negative” is simplistic and sensationalized. There is much more to the issue. The negative price of oil is related to the May futures contracts and not the overall price of oil. It can be attributed to what can be termed as a technical anomaly in the pricing of oil.
We hope to lessen the feelings of impending doom and panic that headlines may invoke, but we don’t wish to diminish the severity of the problems facing the energy industry.
A perfect storm of three primary issues has engulfed the industry:
- The COVID-19 pandemic has drastically lowered global energy demand
- A price and production war between the second and third largest oil producers in the world, Saudi Arabia and Russia
- Crude oil futures contract expirations
A simplified explanation of a crude oil futures contract is an agreement between two parties as to both the price and future delivery date of a barrel of oil. These contracts are timed as monthly contracts. For example: August 2020 contracts are priced at $23.23 per barrel, December 2020 at $28.25 and December 2021 at $33.80 per barrel. These are only examples as prices are extremely volatile.
“Spot Price” is when the commodity is purchased "on the spot" at current market prices for immediate delivery. The current spot price is approximately $14.00 per barrel.
The two major benchmark futures contracts are:
- A barrel of West Texas Intermediate Oil, for an agreed upon price, delivered to Cushing Oklahoma at an agreed upon future date.
- A barrel of Brent Crude Oil, for an agreed upon price., delivered to various locations on an agreed upon a future date. This is “North Sea” oil consisting of production by the United Kingdom, Norway, Denmark, Germany, and Netherlands.
The term “delivery date” is the key component as we discuss the negative price of oil. The May futures contracts for West Texas Intermediate Oil delivery in Cushing, Oklahoma are expiring. Since there is no more storage capacity in Cushing, contract-holders were forced to “dump” their May contracts to avoid physical delivery. As mentioned above, the current spot price is approximately $14.00 per barrel, August 2020 contracts are priced at $23.23 per barrel, December 2020 at $28.25 and December 2021 at $33.80 per barrel. Again these are only examples as prices are extremely volatile.
- The COVID19 pandemic has drastically lowered global energy demand.
The only real solution comes when the economy is opened as sensibly as possible. Therein lies a conundrum for our local, state, and national leaders. We cannot fight COVID-19 without our vast economic resources. But at what risk to health of our citizens? While many envision government resources to be infinite, the reality is that those resources, fed by the strongest economic engine the world has ever seen are in fact finite. At what point in the COVID-19 battle is the damage to our economy so great that it affects the long-term health and welfare of our citizens in a dozen other ways? Unfortunately, it is beyond human capacity to answer this question. As mentioned many times in our past updates, we have survived world wars, terrorism, natural disasters, and a multitude of other challenges. We will meet this challenge as well and be stronger for it.
- A price and production war between the second and third largest oil producers in the world, Saudi Arabia, and Russia. (The USA is number one).
Russia’s reluctance to adhere to fundamental economic principles as it relates to supply and demand for the global oil industry can only lead to speculation. Energy is by far their largest export which also makes it the single largest contributor to their federal budget. They have less storage capacity than the United States. Russia also has an extreme wealth gap which may create enormous strains on their population but at the same time, they may believe they can outlast other oil global competitors with sustained lower oil prices.
While Russia was the one that walked away from the negotiating table, Saudi Arabia has a higher current production level. For both countries, it would be a significant gamble with regard to internal politics and their positions as global competitors, if in fact their goal were to create long-term damage to the U.S. energy industry. Without question short-term damage has already been done.
According to the first-quarter Energy Survey by the Dallas Federal Reserve, U.S. energy firms on average need West Texas Intermediate Crude Oil priced in Cushing, Oklahoma, to be at or above $29 to cover operating expenses. Until the economy opens, we will have some firms go out of business, see more consolidations and others will continue to operate under bankruptcy protections. We do note that the energy industry makes up a large percentage of the high-yield bond market, and we exited almost all high-yield positions in March of this year.
While we tend to equate oil use with the gas we put in our car, it has use in almost every manufacturing process and in the possessions we own. Look around the room and see its impact - computers, phones, furniture, pens, anything plastic, fabrics, paint, packaging and quite literally a million other items. Additional government stimulus will help but that will only create another Investment Update on the perils of massive government debt.
Please feel free to call with any questions and we wish that you and your family stay safe and well.