Texas Tea Is Free!?!

At one point in April 2020, a barrel of West Texas Intermediate (WTI) crude oil for May 2020 delivery dropped to -$38 per barrel. The price somewhat recovered from the record low, but June WTI oil contracts dropped to under $10 per barrel on the following day and have remained under pressure ever since. To be completely transparent, I didn’t think it was technically possible to have negative oil prices but here we are.

Just like everything, prices are set by supply and demand. In normal times, the world experiences greater demand as time passes due to more people, more cars, more industry, etc. etc. In recent times, global oil demand has continued to grow but at a slower rate. Historically, the Organization of the Petroleum Exporting Countries (OPEC) was able to control prices by essentially increasing and decreasing global oil supply on command. Some of that price control power has eroded due to the rise of U.S. shale oil.

HOW IS IT POSSIBLE FOR THE PRICE OF OIL TO BE NEGATIVE?

There are a couple extraordinary factors at play for this to be possible:

1. Global oil supplies have outpaced demand, which has pushed oil prices lower. Demand has all but cratered due to virus induced economic shutdowns (e.g. less cars on the road, limited planes in the air). Supply has remained too high despite OPEC’s “too little too late” pact to cut approximately 10M barrels per day (which was agreed to begin in May). However, depending on what perspective you take, the U.S. is just as much to blame due to U.S. independent oil producers’ inability to “turn off” the oil faucet. For many U.S. oil producers, it’s better for them to keep pumping oil and store it with the intention to sell later rather than cut production off completely.

2. Oil storage tanks are believed to be full. Understanding storage levels isn’t straight forward. There are various types of oil storage facilities, including “floating” storage at sea, which are difficult to fully account for. Think of this like a storage unit one would rent if you were moving and had to keep your stuff somewhere until your new home was ready to be moved in to. Now imagine if everyone decided to move at the same time and there were only a couple storage units left. Naturally, the price to rent those storage units would increase and many people would be left without a place to temporarily store their things. In certain circumstances, you may even need to pay a junk collector to come pick up your old bedroom furniture that you no longer want, just to get rid of it (since you need to move out and you can’t leave it in your old home that now belongs to someone else).

While the situation is complicated, the two factors listed above get to the core of the negative oil price phenomenon. Essentially there is a lot of oil that needs to either be used or stored. Since nobody can use it, and there is nowhere to store it, storage costs are rising as prices are falling leading to near term negative prices.

SO WHY DOES THIS MATTER?

The many implications of rapidly falling oil prices, and in this case negative oil prices, are complex and far reaching. As it relates to the market, the direct performance impact is small as the energy sector is now around 2.5% (and shrinking). That statistic alone is incredible considering that when I began my career the sector was well over 10% of the S&P 500. However, the impact on the real economy is much more pronounced, particularly in oil heavy states like Texas (the 2nd biggest contributor to overall U.S. GDP) as it relates to jobs and potential bankruptcies that could lead to financial system stress. Also, low gas prices don’t help as much as they used to (especially when no one is driving anyway), because of the large amount of oil that is sold and exported internationally.

A separate, but interesting observation, is that one could look at the turmoil in the oil market as an indicator of what’s really happening to the global economy. The reasoning is that oil demand is greatly affected by global growth expectations (i.e. how strong the economy will be in the future). Also, oil is a market that hasn’t been directly manipulated by the Fed or any other central bank (unlike the credit and stock market).

SO WHAT’S NEXT?

The good news is that oil price expectations over the long run haven’t collapsed yet. A more dramatic oil price reset on longer dated oil futures contracts would be disastrous for the oil industry and would potentially indicate a very severe deflationary environment. Given the shock and awe of this very odd scenario, it’s likely that the major players step in to stabilize prices sooner rather than later. Regardless, this is a development we need to watch very closely. Despite the explanation of what’s happening, it’s still hard to rationalize that you could buy a happy meal at McDonald’s for about the same price as a barrel of oil.

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