Crude Oil decimation - why did it happen and what it means for economy

Lets look at why #crudeoil prices moved in a dramatically unstoppable decline yesterday and what do they really mean for the risk markets.

But before that: a little fact of the day: Previous low record for #crudeoil price was $10, set in 1986.

What Really Happened?

The negative price reflected May contract, which is near expiry, and is therefore highly illiquid. Those long the contract would be forced to take delivery of barrels of oil. June contract, where we have bulk of liquidity, closed above $20, and is far more reflective of WTI price as a whole. Thus a drop to negative $40/barrel is really a financial action of someone losing their shirt, rather than a reflection of true market.

The difference seen between May and June contracts, about $60, was the largest ever seen, between two back-to-back monthly contracts. It is called “contango” in financial lingo. Quite a few people are taking this to be indication of market expecting stronger demand in future. Others are taking this to be reflection of a dramatically weak market in near term. Truth is somewhere in between.

Why Did It Happen?

Demand is weak. About 20% of global demand has been taken offline driven by global shutdowns. According to IHS Markit, there will be an oversupply of 1.8 billion barrels of oil by June. Market is oversupplied despite the production cuts by OPEC. This has created a storage problem causing storage to become more valuable than oil itself. It is causing “shut-ins”, which means halting drilling and refining as there is no place to store oil.

Implications for Future

Enormity of this event cannot be overemphasized - this pressure on storage is a reversal of energy psychology. Contingency plans for countries historically involve making sure there’s enough oil stockpiled to withstand a supply shock—rather than making sure there is enough storage itself.

This basically means, negative prices are highly likely in future, unless production fully grinds to a halt. Last week,  Bloomberg reported that some sellers in Texas were already selling off crude for as little as $2/b. Fortune magazine had reported earlier that disappearing spare storage capacity would stop drilling and refining of oil in many regions. The worst-hit regions are Alberta, Venezuela, and Iraq, where about 1.9 million barrels/day have been taken offline so far in April. Storage space in the Cushing facility in Texas is also reducing at a fast clip, according to the U.S. Energy Information Administration pointing to a looming logistical issue. Even “floating storage,” or using oil tankers as offshore storage for oil when space is tight—are also not viable options at the moment. As per Rystad Energy, an Oslo based energy consultancy, there are only 57 oil tankers that used to further store surplus oil.

A wave of bankruptcies will hit energy sector causing large layoffs, distressed asset sales, debt restructuring. To give context, in 2015-16 downturn, US lost one third of the workforce in energy sector.

As companies will abandon most expensive areas of production first – the onshore operations, there should be concern around potential for operators to default on decommissioning and environmental obligations.

For PE firms with dry powder, this is good news - they will be able to buy assets at fire-sale prices very soon in an industry that will be profitable in long term.

In second order effects, job cuts and lack of investment by energy producers can have a significant impact on businesses in the energy supply chain. A drop in orders for new drilling equipment can hit industrial suppliers, while job losses can have a significant impact on local economies.