What Does a Negative Oil Price Mean?
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Today's headlines were dominated by a paradoxical piece of news: the price of oil has gone negative, briefly reaching -$37/barrel USD. But what does that actually mean? How is the price of oil measured? Can I buy all the oil in the world and lock in an enormous profit? What does this mean for the economy, in the near, intermediate, and long term? And why does this all revolve around Cushing, Oklahoma?
The chart below shows the progress of the price of WTI this year, and has been updated to allow for negative figures:
Source: Bloomberg, April 20th
Why is the price of oil low in the first place?
Context is important here. We're nowhere near having this conversation unless:
- COVID-19 causes a steep drop in the demand for oil
- OPEC and Russia embark on a price war, redlining production in order to tank the price of oil
- Decreasing oil production rates is difficult
That's why oil is cheap everywhere in the world. Understanding why the price of oil reached negative levels today requires digging into the way oil is stored and traded in the United States.
There is more than one price of oil
Oil is sold both in physical form and as futures contracts, which are contracts to deliver oil at a specific time, and in some cases to a specific place. This is important to note, as the price of most oil is still positive. The headlines talking about the "price of oil" reaching negative levels are talking about the price of a barrel of WTI oil that will be delivered in May.
Oil is traded in different grades, or benchmarks, around the world. The benchmark in Canada is Western Canadian Select (WCS). The benchmark in Europe is called Brent Crude. If you look at WCS and Brent prices, you'll see that both are positive. In the United States, the relevant benchmark is called West Texas Intermediate (WTI). Contracts for May deliveries of WTI require delivery to a storage facility in Cushing, Oklahoma, and this is where the trouble started.
Oil storage in Cushing, Oklahoma. Source: Bloomberg
Since demand for oil has fallen off a cliff and production was maximized as part of a price war, we're starting to approach the limit of global storage capacity. Today, traders realized that the storage capacity in Cushing, Oklahoma is all spoken for, and everywhere nearby is either full or nearly full. Traders don't want to take delivery of oil at that facility in May, because there's nowhere to put it and nobody that wants to buy it, so they're selling May delivery contracts and buying contracts that will deliver in June. This forces the price of May delivery contracts into negative territory, as traders are balancing the cost of taking delivery against the cost of paying someone else to take it.
The problem is not that oil now has negative value, but that the costs associated with a specific contract for oil exceed its benefits by about US$20.
If this is a storage problem, why can't I just--
Way ahead of you. Here's the math:
*Assumes 10 ft ceilings
Source: Bloomberg, April 20th
If you could somehow take delivery of May 2020 WTI contracts in a Yaletown apartment, you'd stand to profit immensely.
The point is that you couldn't take delivery in a Yaletown apartment, and that everywhere you could is either full or extraordinarily expensive. Chartering ship will cost you US$350,000 a day, and that's after you get the oil onto the ship. That's why traders are paying people to take May WTI deliveries off their hands: there's no good place for them.
What does this mean for the economy?
Typically, a low price of oil indicates two things: a low level of economic activity and a low cost of economic activity. Economists use the price of oil as input in models that help them project future economic performance, and those models are currently making very grim projections.
We should consider that many of the variables that add up to a negative oil price are not exactly organic. Demand is being suppressed by extraordinary and temporary controls on economic activity. Production and supply were spiked by an intentional, economically inefficient price war between OPEC and Russia. The costs of taking delivery of a barrel of oil in May are elevated by the requirement that the oil be delivered to a specific facility.
Obviously a negative oil price is not good news for economy. But if you're looking at an economic model that suggests that a depression is coming, ask yourself: does this model consider the possibility of storage problems causing prices to temporarily go negative? Does this model consider the possibility of oil producers making intentionally irrational decisions? Or could these be circumstances that would produce a false positive?
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Disclaimer: Canaccord Genuity Corp. is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and Canadian Investor Protection Fund (CIPF). The comments and opinions expressed in this commentary are solely the work of the Cash Management Group and Andrew Johns.