April 20th, 2020 will go down in oil-market history as the day when the U.S. benchmark price for crude dropped below zero for the first time, meaning that producers would pay traders to take oil off their hands. In a massive and unprecedented swing, the future contracts for May delivery of West Texas Intermediate (WTI) tumbled to minus $37.63 a barrel.
The modern oil industry can trace its origins to Baku in 1837, where the first commercial oil refinery was established to distill oil into paraffin (used as lamp and heating oil). The main factor that impacts the price of oil is supply/demand, which is a straightforward concept. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. To understand the origin of this oil prices crash we only need to split these two components and see what happened in the first months of 2020.
The Levers of The Crisis
As the virus started to spread around the globe, the demand of oil started dissipating. Just as countries like Italy showed what kind of damage a national lockdown could do in terms of economic impact, Saudi Arabia and Russia, the world’s biggest oil producers, escalated a price war. Oil is a geopolitical game, and big price swings are often caused by geopolitical tensions. This story started in February as OPEC+ producers tried to negotiate a production cut amid concerns that COVID-19 could have heavily impacted demand.
On March 6th OPEC+ talks collapsed with Russia walking out from negotiations. Two days later Saudi Arabia responded by undercutting oil prices by $6-8 per barrel offering such discounts to customers in Europe, Asia and the US. The world went into lockdown with the WHO declaring Covid-19 a pandemic on March 11th and energy demand plummeted while oil producers continued to pump at will. Then on April 9th, nearly a full month after the declaration of the WHO, Russia and Saudi Arabia finally settled their differences. This truce, however, came too late and prices had already fell about 60% from February highs. The world experienced, at the same time, two disruptive events for the oil industry: on one hand a demand crash, and on the other a supply overhang.
This oddity of negative prices was also partially a function of the particularities of futures contracts. Futures contracts normally rollover to the following month without much happening, however, in this case traders saw the May contract as a “hot potato”. No one wanted to be stuck taking delivery of oil when the world was awash in it and the country was in lockdown. Moreover, oil futures contracts specify a time and place for delivery. For WTI oil, that specific place is Cushing, Oklahoma. Cushing is composed by 15 storage terminals and it is the centre of a network of nearly two dozen pipelines, carrying over 6.5 million barrels per day. With most storage capacity booked already, taking physical delivery wasn’t even an option for many players. In other words, sellers outnumbered buyers by a very large margin and because oil is a physical commodity, someone must ultimately take the contract.
Mitigating the Shock
What do you do when oil is practically free? You store as much of it as you can, and hope that at a certain point you can sell it for more. Unfortunately, everyone had the exact same idea, resulting in a historic glut that was filling up the world’s storage capacity both on land and at sea. In March, it was estimated that 76% of the world’s available oil storage capacity was already full and a record-setting 160 million barrels of oil was stored on tankers at sea, according to Reuters.
The cost of renting an oil super tanker went through the roof, jumping from $20,000 per day to $200,000-$300,000 per day, according to Rystad Energy. Crude stockpiles at Cushing in Oklahoma jumped 48% to almost 55 million barrels since the end of February. The hub was working storage capacity of 76 million as of Sept 30th, according to the Energy Information Administration. The industry had been accumulating supply aboard ships, while contemplating other creative options such as storing oil in rail tanker cars. The Trump Administration, which was concerned about the possible ripple effect from oil bankruptcies, was eyeing the proposal of paying drillers to keep their oil in the ground temporarily. The idea would have been to keep it off the market until prices recovered, giving the Treasury a healthy profit eventually while protecting producers from immediate losses.
Back to Normal?
In the last weeks oil stocks have made a big comeback since the recent announcements of effective vaccines in November stirred hopes that a demand recovery was near. With oil major share prices down by about half this year ahead of Pfizer and BioNTech’s November 9th announcement, they have since risen by more than a third. The industry has a lot more to gain than many other sectors from the post-Covid “return to normal”, in whatever guise that might take.