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Problems in store: what’s going on with oil prices?


Mark Herlihy

Mark Herlihy

Investment Writer

Schroders

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As countries around the world went into lockdown to curb the spread of the deadly Covid-19 virus, demand for oil collapsed. And on Monday something quite extraordinary happened; the price of West Texas Intermediate (WTI), the grade of crude oil used as a benchmark, turned negative for the first time ever.

This means that oil producers are paying buyers to take the commodity off their hands due to fears that storage capacity could run out.

Although weaker demand and an uncertain short-term outlook played a part, much of the reason for this sharp fall in the price can be explained by a technicality of the global oil market and a lack of storage capacity. Oil futures contracts relate to specific delivery periods, and the current WTI contract for deliveries of crude oil in May was due to expire on 21 April.

Unlike Brent (one of the other main benchmarks for oil prices), WTI contracts are settled by physical delivery, with the owner of the contract on the day of expiry getting the barrels of oil. With many oil traders in the financial markets unable to take physical delivery, there was a rush to offload these holdings to avoid having to incur storage costs.

Earlier this month, the Organisation of the Petroleum Exporting Countries (OPEC) and its allies agreed a deal to cut global oil output by around 10%. This was the largest reduction in oil production ever agreed and followed a price war between Russia and Saudi Arabia. However, many analysts said that the cuts weren’t big enough to cope with the fall in demand.

US president Donald Trump has dismissed the price fall as a short-term problem and has pledged to buy up some of the oil for the country’s national reserves. However, with storage capacity at the WTI hub in Cushing, Oklahoma (the main delivery point in the US for oil) set to run out in the middle of May, concerns are growing that this may prove to be a more long-term problem.

To assess the impact of negative oil prices on the wider economy, we spoke to Keith Wade, Schroders’ Chief Economist & Strategist, and Mark Lacey, Schroders’ Head of Commodities.

Keith Wade, Chief Economist & Strategist:

“Under normal circumstances, lower oil prices help households by pushing down inflation and boosting spending power. At the moment though that’s not happening as people aren’t driving and most retailers are shut for the lockdown. So there is little opportunity to receive the benefit and spend more elsewhere.

“Once the lockdown is lifted there would be an opportunity to spend, but demand for oil and fuel prices will also rise at that time so it’s hard to quantify. On balance I would see this effect as a minor positive for most oil consumers.

“However, there is a significant negative as oil producers have to cut back on production to match demand and financing costs have risen steeply for the sector. Shale gas producers are already cutting their capital investment and this will drag on activity and deepen the recession in the US before any consumer benefits come through.”

Mark Lacey, Head of Commodities:

“The biggest impact will be bankruptcies. Despite many oil companies cutting capital expenditure by up to 50%, many, many companies are going to go bankrupt. Around 80 oil and gas companies filed for bankruptcy in the 2015 sell-off. The current situation is far worse than 2015, so the industry is going to look very different after this wash out. These bankruptcies will not be limited to the US, but will also likely occur in Asia, Latin America and Europe.

“At current prices, many oil companies around the world are starting to “shut-in” production. This is when they put a cap on production that’s lower than the potential available output.  

“At the start of March the shut-ins were gradual but they are now accelerating and a lot of these will be permanent, with many fields potentially not restarting even if prices recover back to $60-$65 per barrel. Industry research suggests that as much as four million to seven million barrels a day could be permanently lost as a result of these shut-ins.

“Monday’s price action was the result of physical traders that had committed to taking delivery in Oklahoma not being able to store the crude, to the point that they had to pay storage holders one-off payments of between $40 per barrel and $50 per barrel to hold the crude for a few days.

“I would expect the June and possibly July WTI contract to remain extremely volatile over the next few weeks as full storage in Oklahoma is unavoidable. However, it’s important to point out that this is not specific to the US market. Around the world, storage terminals will fill up and this will force even bigger cuts from OPEC and non-OPEC producers.

“The shock to the global oil market as result of Covid-19 restrictions is unprecedented. The oil market has never experienced a fall in demand of this magnitude. From what we are already seeing, this will have a long-term impact on the supply dynamics of the oil industry for many years to come. And despite recent cuts to production, the most important driver for any recovery will be demand.”

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

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