When oil sellers paid buyers to just take it

On April 20, those who were looking at computer monitors in the US could not trust their eyes. May oil futures for the benchmark West Texas Intermediate (WTI) were showing negative prices. After reaching minus (-) $40 per barrel, oil prices finally ended at -37.63/b -- a historic drop of $58/b in one day.

The impact of the COVID-19 pandemic has caused many historic firsts – the maximum daily drop in oil prices, unprecedented demand drop and production cuts, and historic support to OPEC+ by G-20, and the event which will be written in the history books is that of the ‘black gold’ being sold at negative price.

How did this come about? The simple explanation is that the May oil contracts would have expired within a day and those who hold contracts have to take physical delivery of oil. Under normal circumstances, this is not a problem. However, there was no storage available. International benchmark Brent futures not only did not fall in negative territory, but showed only a small decline of $2.5/b. In the case Brent futures, cash payment is allowed.

But to understand and appreciate how we ended up with the negative price, we need to learn more about the latest oil drama. This was stage-managed by the world’s “greatest” deal maker, US President Donald Trump, with the help of Russian President Vladimir Putin and Saudi Arabia’s crown prince, Mohammed bin Sultan.

When Russia walked out of the OPEC+ meeting on March 6, oil price dropped to the lowest level since August 2016 and it set the stage for the oil drama, which took place from April 9 to 12. Trump, Putin and MBS thought that they could control the price. In reality, it was the little invisible creature, coronavirus, which was really in charge.

Finally, the OPEC+ ( OPEC plus 10 more oil-exporting countries, led by Russia) agreed to reduce crude oil production on April 9. The next day, G-20 members supported the agreement by agreeing to cut some more.

Soon after the agreement, Trump trumpeted that the negotiated reduction is 20 million barrels per day (mmbd) and not 15 mmbd as reported in the media. When a realistic estimate is made, the true reduction may be around 10 to 11 mmbd.

Because of the lockdown in most countries, oil consumption had already collapsed. One need not be a genius to figure out that the oil inventories will reach historical highs by the end of April and put pressure on storage, which is getting filled rapidly.

According to IEA, the oil demand is likely to drop by 29 mmbd in April and for the whole year, it may drop by 9 mmbd. It is likely that the demand may recover only by a small amount in May and not much in June. Some experts estimate the demand drop in April maybe more than 35 mmbd.

Never in global oil history has the demand fallen so much so rapidly. Unless the global economy picks up within a few months, the oil demand drop may be even larger. Therefore, the production cut stage-managed by the three actors will not be enough to balance demand and supply.

It is indeed a mystery why OPEC+ had to wait for May 1 to implement their production cuts. By early April, there were clear signs that there will be a scramble for storage. Shippers were getting attractive offers and so also those who owned storage space.

Despite such a dramatic development, Saudis and Russians were competing against one another to increase their market share before the production cuts kicked in. While oil companies -- large and small -- in the US and other countries were forced to cut production by market forces, the cuts were not enough to balance supply and demand.

However, if the coronavirus pandemic and death rates start declining quickly, there could be a quick V-shaped economic recovery. In this scenario, oil prices may recover and go over $60/b by the end of the year. But it does not look likely as per the current scenario.

The futures market, although not very reliable, is reflecting that oil prices will climb to around $30/b by year-end. Such an increase will not support shale oil production in the US. That in turn does not help Trump’s re-election campaign. For most shale producers, the break-even cost is around $40/b or higher. As a result 2-2.5 mmbd of shale oil production is likely to be shut down till the market fully recovers and oil price rises above the break-even cost. There will also be market-driven production cuts in other countries which will result in a fairly balanced or tight market if and when the demand picks up later in the year.

But in today’s market, experiencing a ‘black swan’ event due to which demand for oil has dropped 25-35%, neither the OPEC+ nor the non-OPEC members of G-20 can do much to support a higher price. The old strategy of the cartel allocating production quotas will not work.

The historic negative price is another proof of market power when demand is controlled by the little invisible creature and not by any economic factors. Finally, it is the market that will decide who will produce oil depending on who can produce it at below break-even cost. Based on IEA analysis, such a break even cost is around $15 per barrel.

In short, until the lockdowns are lifted in most countries, airplanes begin to fly and economic engines start to hum, even if not to full capacity, and demand reaches over 90% of the pre-pandemic levels, oil prices will be controlled by coronavirus, and not by OPEC+ or President Trump.

(The writer is a veteran oil industry professional)