Oil be back

Mathias Talmant
3 mai 2020
17 min de lecture

COVID-19 Series

Abstract

As you must have read in the press, WTI futures for delivery in May-20 turned negative on 21/04/2020. In this issue of the COVID-19 series, I will cover the following topics:

- OPEC tensions and the origins of the supply glut.

- the market dynamics behind a negative oil price.

- my takes on the direction of the oil market along with the S&P500.

- the new paradigm of US shale oil and impacts on petrostates’ economies.

- the incidence on retail gasoline price at the pump.

Before I jump into the heart of the matter, I would like to give you a quick refresher on oil basics. If you are already familiar with the black gold, you can skip “1 0il 1” and go straight to the section “Bear vs Camel: the 2020 oil price war”.

1 0il 1

What is the black stuff?

Crude oil is a naturally occurring fossil fuel, meaning that it formed from the remains of marine plants and organisms that lived millions of years ago. By its very nature, oil reserves are scarce, hence the need for renewable energy. In its original state, crude oil is worthless, but it can be refined to produce usable products such as gasoline, diesel, jet fuel and petrochemicals.

Crude oil is typically obtained through drilling onshore or offshore. As showed on the illustration, a reservoir contains gas, oil and water, from the lighter to the denser. At the risk of disappointing you, “black gold” can vary in colour from black to yellow depending on its chemical composition.

Source: 123RF.

Crude oil is a global commodity that trades via spot and futures. It is a key source of energy whose price dynamic is mainly ruled by the law of supply and demand. An increase in demand is often interpreted as an expansionary economic cycle and vice versa.

The highly coveted liquid emerged in the 19th century as the Industrial Revolution unfolded and since then, it constitutes a strategical natural resource that has sparked many social unrests. It is the largest source of primary energy, along with coal and gas. The United States, Saudi Arabia, and Russia are the biggest guys in the room.

The two most popular grades

Source: MT Finance.

Who are the oil men?

The OPEC (Organization of the Petroleum Exporting Countries) was founded in 1960 and included 13 nations. In 2018, it accounted for 44% of global oil production and 81.5% of the world’s proven oil reserves. Given its large capacity, Saudi Arabia is the de facto leader of the organisation.

In 2016, the cartel was extended to include 10 OPEC+ member states, led by Russia, in an attempt to offset the American booming shale production. This group of petrostates typically sets a production target for its members in order to cap oil supply so that oil prices can inflate. This agreement is crucial for these nations whose budget is essentially balanced based on the price of a barrel of oil.

However, the influence of OPEC on international trades is periodically challenged by the expansion of non-OPEC energy sources, and by the recurring temptation for individual OPEC countries to exceed production targets and pursue conflicting self-interests. In a way defined by the “free rider” concept in sociology, some petrostates may try to benefit from OPEC’s self-imposed targets without applying them themselves. In other words, some countries can take advantage of other’s limited supply to produce more at an inflated price. This brings us to the next section on 2020 oil price war.

Bear vs Camel: the 2020 oil price war

Set up the scenery

Oil majors have long been facing the spectre of depressed demand due to climate concern, but the wraith came in the shape of a black swan, name it COVID-19. Crude fuels transport, but since governments have limited travels to contain the pandemic, oil demand has never been so low. If that was not enough, a brawl between Saudi Arabia and Russia has led to a price war and Brent fell below $23 a barrel in March 2020. The steepest slide since 1999.

So far, OPEC members agreed to tighten their belts and slash their oil production to put pressure on the US and keep prices high enough to balance their budgets. The fallout of the cartel’s strategy is diametrically opposed to expectations since America kept the tap open and became the world’s top oil producer in 2018, ahead of Saudi Arabia and Russia. That pushed oil prices high enough to shore up investment in American shale but too low to balance the budgets of Saudi Arabia and other petrostates.

Declaration of war

Since the pandemic shut down most factories and transport infrastructures, demand for oil nosedived, especially in China, which triggered an OPEC summit in Vienna on 5 March 2020. OPEC agreed to cut oil production by an additional 1.5m bpd through 2Q20 (a total production cut of 3.6m bpd from the original 2016 agreement).

Tired of being overshadowed by the United States, Russia gradually overlooked OPEC+ self-imposed production cuts, and on 6 March, it rejected the OPEC’s demand, which forced Saudi Arabia to curb its own output more sharply. President Trump’s earlier sanction on Russia’s largest oil company Rosneft in February 2020 may also be another motivation to retaliate.

Either way, this marked the end of the unofficial partnership. On the announcement, oil prices fell 10% and Saudis declared the price war.

In the Middle East, the kingdom still wants to balance the oil market but is tired to be the only “swing” producer. On 8 March, Saudi Arabia announced unexpected price discounts of $6 to $8 per barrel to customers in Europe, Asia, and the US, triggering a free fall in oil prices. The black gold was on a roller coaster for the rest of March with large intra-day movements as Saudi Arabia and Russia successively announced their intentions to increase oil production. On 20 April 2020, prices dropped below zero for the first time, but I will talk more in detail about this historic event later in this article.

On 2 April, US President Donald Trump claimed that a reduction of 10-15 m bpd in production would be possible, citing negotiations between Russia and Saudi Arabia he brokered behind the scenes. The following day, Mr Putin ordered energy minister Alexander Novak to prepare an extraordinary OPEC meeting hinting that a 10 mn bpd cut may be reached. Even with such cut, the IEA (International Energy Agency) estimated that global oil stockpiles would still increase by 15 mn bpd. IEA's director stated that 50 mn jobs related to oil refining and retail was at risk globally. US oil prices increased by 25% on the same day, the biggest intra-day increase in history.

On 9 April, OPEC and Russia agreed to reduce by 10 mn bpd and the USA expect its production to fall by 2 mn bpd at the end of 2020. However, Saudi Arabia is eager to defend its powerful position and does not want to backpedal yet. Since late March and until late April 2020, the kingdom has loaded several supertankers and started to flood storage in Egypt, a steppingstone to Europe. The movements suggest that Riyadh is ramping up its oil production toward its target of supplying a record 12.3 mn barrels a day in April, up from about 9.7 million in February, despite American pressure to end the price war.

The pandemic has exposed vulnerabilities of petrostates and OPEC. In the first few weeks of March, the price war between Saudis and Russians led US oil, crude and brent 34%, 26% and 24% lower respectively. Oil prices had already fallen 30% since the start of the year due to a sharp fall in demand. This is a double whammy for the oil and gas industry, all the more so as oil revenue is a significant government income for several petrostates. All OPEC members are at risk, but it is worth noticing that Russia (~$50) conserves a large advantage in terms of fiscal breakeven oil price compared to Saudi Arabia (~$84). It is a price war that no one looks likely to win.

“In a few years’ time, when we look back on 2020, we may well see that it was the worst year in the history of global oil markets,” said Fatih Birol, the head of the IEA. Demand for oil is low and tanks are so full that negative oil prices may be common in the short-term. According to Citigroup, global supply needs to fall by 12% (10m barrels a day) for tanks not to spill over.

A quick look oil around the world

United States

The crash will not impact everyone equally. After years of running on high debt and pumping oil at a loss, even at $20 a barrel, many small companies will be forced out of business. For all that, the oil industry is not doomed. Many shale firms are hedged against falling prices this year, but those on their knees may well be taken over by bigger competitors like ExxonMobil. We will witness the survival of the fittest in the most base way. The first casualty was the American Whiting Petroleum Corporation, which produced 120,000 barrels per day and filed for bankruptcy on April 1, due to the price war.

It is tricky to turn off the tap of an oil well, but it surely is easier to slow down drilling of new wells. At $35, only 16 North American shale producers could operate new wells profitably and they generally need $40 a barrel to sustain existing operations. Consultancy Wood Mackenzie estimated that with Brent at $25/barrel, 10% of oil production globally would not be able to cover its base operating cost, particularly heavy crude oil producers such as Venezuela, Mexico and Canada, where the price dipped below $5 per barrel.

Saudi Arabia

Saudi Arabia has borne most of the burden of production cuts in OPEC. After years of belt tightening and little support from allies while American shale producers gobble up market shares, we can understand the level of tensions in a nation whose fortune lies in a single natural resource. Yet the decision to open the spigots is a risky bet while the world manufacturing and transport industries are at a standstill.

Despite having one of the lowest operating costs of just $3.20 a barrel (one-third of America’s), Saudi Aramco, the oil firm with the most superlatives, announced a cut in capex from $35–40bn to $25–30bn (-27%). The government also increased its debt ceiling from 30 to 50 percent of GDP, due to both oil prices and the impact of the pandemic and plans its budget deficit to rise from 6 to 9 percent. Not surprising given that the Saudi economy requires $84 a barrel to balance its budget.

Russia

Mr Putin initially forecasted a $11bn surplus for 2020, but is now reckoning on a deficit as it took a double hit from oil price and rouble collapses. Russia is in a position of relative strength because it can balance its budget with oil around $50 a barrel and has more than $500 bn in foreign reserves. On March 10, Russia’s finance ministry said that the country had enough foreign-currency reserves to withstand a decade of prices hovering between $25 and $30.

From zombie companies to ESG

COVID-19 is not all gloom and doom. Lessons will be learnt, zombie companies will give up the ghost and the world will rise up stronger than ever. Many firms will take their skeletons out of the closet and blame it on COVID-19. This means 2020 will be a write-off, many non-cash charges will be recorded and unprofitable projects will finally have an opportunity to be pruned in a smooth way. We never pray for devastation, but there is always a silver line to the cloud after the storm. This crisis will sweep off the rotten fruits and hopefully, big and responsible money will come to foster healthy development projects.

“The stone age did not end because the world ran out of stones, and the oil age will not end because we run out of oil”, said Don Huberts from Royal Dutch Shell. The stone edge ended because we evolved into the iron age and now is time to evolve into the renewable age. In the 18th century, Thomas Malthus claimed that populations grew geometrically, while natural resources grew arithmetically, and this theory has never been so true. We do not have enough Earths so sustain our current lifestyle. Both energy production and consumption habits have to be optimised.

Fatih Birol, Director of the International Energy Agency believes that “governments can use the current situation to step up their climate ambitions and launch sustainable stimulus packages focused on clean energy technologies.” Since governments drive 70% of global energy investments, directly or indirectly, they have “a historic opportunity today to steer those investments onto a more sustainable path”, said Mr Birol. Nowadays, wind and solar energy projects are more affordable than a few years ago and record low interest rates are also supportive. There were 50% more shale bankruptcies in the US last year. In 2020 more inefficient companies will vanish and some wells, once closed, are too costly to reopen. With depressed oil prices, thousands of jobs will be at risk, but the return on renewable projects will finally rival that of a new oilfield and hopefully, with time, we will observe a shift toward green energy.

Sp-oiler Alert : WTI was killed by COVID19

On April 21, pandemonium broke out in the oil market when WTI buyers were paid to take delivery in Cushing, Oklahoma in May. It was the first time ever oil was less than worthless, mainly because of oversupply and lack of storage.

Trump puts in his two cents

“Trumpnomics” stroke back on April 2 as the US President twitted a deal was imminent between the two belligerent states. This pushed Brent up by 20%, the biggest one-day gain since 1986. Trump suggested to pay oil producers for oil still in the ground and consider it as part of the US’ strategic oil reserves. A good idea on paper, because suddenly storage capacities would be extended and get very cheap, leading the storage cost (u) lower and thus letting the future price converge with the spot price. Here is the formula of the theoretical price of an oil future contract expressed as a function of its spot price.

At the moment, storage cost is the most important component of the equation of the future price since risk free rates have been hammered down by Central Banks. Convenience yield is non-existent as there is no premium associated with holding physical oil rather than the associated derivative security with such high storage costs. Unfortunately for Mr Trump, but fortunately for American citizens, he is not an autocrat presiding over a petrostate, so his idea was rejected by Congress. You never change a losing team, so the President suggested to levy a tariff on imported oil, which would benefit some of America’s 9000 oil and gas producers, but harm integrated giants like ExxonMobil.

As shown on the following graph, WTI prices for future delivery have risen well above the spot. This situation is referred to as “super-contango” and occurs when the inventory space to store the physical commodity is running out due to excess supply – meaning that the cost of carry (the cost of storing a physical commodity) in a futures contract increases. To get out of super-contango, over supply needs to abate to let inventories be used up so that storage space increases. Until the stockpiles are depleted, the price is unlikely to rise, but as mentioned before, cutting supply takes time and even though OPEC stroke a deal, tensions are still high as Reuters reported on April 27 that Russia was stealing Chinese oil market share from Saudi Arabia.

Storage is the new black gold

Where to put it is the problem. Storage at the critical transport hub of Cushing, Oklahoma, was 70% full in April. Black gold will now refer to the empty spaces to hold crude, rather than the liquid itself. Crude inventories have been rising at an average of 16 mn barrels per week in April, which implies that spare capacity will fall to critical levels in the coming months if tank farms continue to fill at this rate.

As explained by Reuters, “working storage capacity is the part of the tank from which crude can readily be withdrawn; it excludes tank bottoms, where pumping cannot effectively remove the oil. Even so, working storage capacity cannot be filled 100%; some must remain available for operational requirements such as transfers and deliveries, which suggests the tank system could become effectively full well before working capacity reached 100%.” I do not know exactly what the maximum working storage capacity is, but historical evidence show regional averages in the Midwest were as high as 80% in March 2015.

Sources: Reuters, EIA, MT Finance.

*Forecast assuming US storage keeps decreasing at a constant rate of 16mn barrels per week, as observed in April 2020.

Afloat storage on VLCC (Very Large Crude Carrier) is typically twice as expensive as warehousing crude at a tank farm, but land-based storage is getting so scarce that time charter equivalent is going through the roof. This metric refers to average daily revenue performance of a vessel, a key indicator for shipping companies. In the same manner as oil, the cost of afloat storage is defined by the law of supply and demand. At such price level, the global oil market is clearly showing its vulnerabilities.

Will Brent suffer the same fate?

Probably, although it is more resilient than WTI for several reasons. It is produced in the North Sea and can more easily be placed in tankers. Besides, let us not forget that WTI is the US benchmark while Brent crude is the international benchmark. The United States is one of the most badly impacted by the pandemic, hence the collapse of its oil benchmark. It does not mean Brent is safe, but its price is not dictated by a single economy’s health.

Another significant difference between WTI and Brent is that the former one is physically settled, while the latter one is cash settled. In other words, WTI traders must take delivery of barrels of oil at Cushing in Oklahoma, hundreds of miles from the coast, while Brent traders can simply exchange dollars. Since no one wants oil at the moment and storage are getting full, traders were ready to sell their futures at any price before the contract ends on April 21 and this one of the factor that has led WTI into negative territory.

Why is it not possible to turn oil production off ?

Slow-mo oil wreck

With the global economy in a pandemic-induced coma, there is simply no demand for oil, especially from China, one of the largest consumers in normal times. But why does oil keep flowing out of well filling storage up to the brim and pushing prices below zero?

There are two main reasons. First of all, producers have already diminished supply, but the world economy changed faster than crude can travel through pipelines and that is one source of the delay between oil price crash and oil supply reduction. Thus what we are witnessing is a slow-motion oil wreck.

Besides, producers are very reluctant to turn off the tap because as long as prices are non-negative, wells generate some cash. Even if producers incur losses, they would rather keep a well running and bring in some money than not. When prices are negative, there’s more incentive to shut-in production and yet they may still prefer pumping at a loss because an oil well is not like a light switch you can flick on and off. It can be hard to turn back on and just like a bottle of soda, even if you put the cap back on, it will never be as bubbly as when you first cracked it open. It usually requires more money to get the well to produce at the same level as before, not only because of law of physics, but also because of the law itself. Indeed, many oil producers have signed leases that require them to drill the oil field. If they shut-in, they can lose the lease to a competitor and thus have to buy it back, which entails a lot of money. Therefore, even with unprofitable level of oil price, producers would rather pay buyers to take oil out of their hands in the short-term so that they can keep running wells in the future when oil price rise up (hopefully for them).

The main issue now is storage. According to Rystad Energy, even if they wish to keep pumping, nearly 2 mn bpd have been shut in already, mostly in Canada, because tanks, pipelines and ships are so full that there is nowhere to immediately store oil.

Cap-exit

Another way that oil companies are reducing output is cutting back on new investments. In March 2020, the Dallas Fed Energy Survey reported that on average, US firms need oil prices to be at least $49 per barrel to profitably drill a new well. As a remainder, WTI, the US benchmark, is currently around $17 a barrel. As highlighted on the graph from Enverus, the number of US oil rigs has been going downhill since early 2019, but it accelerated sharply in 2020 since active drilling rigs has dropped to less than 440 versus 825 a year ago.

What’s next?

Shooting in the dark

The COVID19 pandemic crisis is unprecedented, so anyone claiming to know exactly what is coming next would be a fool shooting in the dark. However, 'lower oil price for longer' seems to be a reasonable statement. Citigroup thinks the price of Brent crude will average $36 this year and $56 in 2021. In my view, this is too high. Why?

Apart from geopolitical tensions, I do not see demand picking up anytime soon. A Harvard team’s computer simulation published in the journal Science highlighted that a one-off lockdown would not halt the novel coronavirus, and that repeated periods of social distancing would be required into 2022 since COVID-19 is likely to become seasonal. Even without a lockdown, the threat of a second wave of infections is still lurking, so many companies may continue to use teleworking, borders will be closed for longer and supply chains will be temporarily relocated. Knowing that supply and demand is the cornerstone of oil price dynamics, and that we have over supply with little demand, I expect oil prices to remain depressed for longer.

Low for longer

On April 12, petrostates broke bread and reached a new deal to try to prop up price by slashing production by 9.7m barrels a day from May to the end of June and restrain output for two years. This record agreement was seemingly brokered by President Donald Trump whose re-election depends on the shale states of Texas, Pennsylvania and Ohio. However, as COVID-19 keeps workers at home, planes on the ground there is hardly any sign of recovery in oil demand before Q4-20 or even 2021. Besides there will be a lag before effects of the deal can materialise, and there is no firm guarantee that the cumbersome alliance will stay compliant. As a consequence, it would not surprise me to see more negative price on oil futures later on in June or after and in other oil grades like Brent.

Legitimate optimism or dead cat bounce?

March 2020 oil crash is a poke in the eye of the oil cartel and a big reminder to any bullish investor at the moment. The number of infected individuals is still growing fast worldwide. We do not have safe and tested vaccine or any kind treatment yet. Testing kits, face masks are still missing. Supply chains are heavily disrupted, unemployment figures reached record high, most if not all countries will record negative GDP growth and most stores are shut down for several more weeks. And yet, we have seen a rebound of more than 30 percentage points since March 23, 2020. How much of the reversal is down to improvement in the outlook of the outbreak and how much is down to Central Bank support?

Sources: Tradingview, MT Finance

On March 23, the Federal Reserve committed to continue its asset purchasing program “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy”. In other words, quantitative easing infinity mode is back on. Stock markets and riskier bits of the bond market have been rallying, dragged out of the depths of despair by heavy-hitting central banks, but they seem to be the last men standing in front of a cataclysmic economic recession. The Fed has pledged to buy a huge range of bonds, even junk, which has pulled down bond yields and gave incentives to investors to snap up equities, but the Fed does not buy oil.

I personally agree with the Financial Times : “It is perfectly reasonable to buy stocks on the basis that the Fed has your back, and most fund managers would agree that central banks have succeeded in neutralising threats to the financial system itself. But any idea that this is an organic recovery, that companies and economies are through the worst and gliding smoothly back to normal, seems misplaced.”

The S&P500 is now back to where it was in June last year. The spread of the virus has somewhat decelerated in some parts of the world, but the equity rally is most probably too strong, too fast and too soon as more downside risks lie ahead of us. The shock in the oil market is the most striking signal that the global economy is in deep distress. Noting is infinite and helicopter money certainly is not. Quantitative easing and low interest rates are powerful artificial valuation boosters, but revenue and earnings do not lie. In the long run, the S&P500 will be higher because institutional money has nowhere else to go. But in the short-term, investors must look beyond Central Banks’ policies and discount the impact of COVID-19 pandemic on the world economy.

Will we be paid to fill up at the pump?

Long story short, the answer is no. Although the price of crude has been hammered lately, even falling into negative territory, you will still have to dip into your wallet, because crude is not the best predictor of retail gasoline price. Instead, we need to look at wholesale gasoline that, which sets the pace of price fluctuations at the pump. The latter one has not known the same wild swing until now.

Besides, the price of oil accounts for less than 30% in France vs 50-60% in the US. Some costs are non-compressible such as refining, distribution and marketing, which represents the bread and butter of the gas stations. And then come Mister US Tax who levies up to 20% tax. His namesake, Mister French Tax, is somewhat greedier because he levies approximately 62% tax in total. In other words, the positive impact on citizens’ purchasing power of the fall in oil price is largely diluted by the weight of government taxes, especially in France.

Sources: US Energy Information Administration, La Voix du Nord (2019).

However, it is worth noting that according to the French Ministry of Ecological and United Transition, on April 3, if we look back to 2018 and 2019, French gasoline retail prices have lost close to a fifth of their value. However, it seems like drivers still have some leg room before they push the pedal if they want to take advantage of gasoline price as low as in the previous supply gut in 2014-2016.

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

MT Finance - Mathias Talmant.