What to make of the collapse in oil prices

bucky

Hard luck, Dr Bucky! On Monday (20th April) the price of a key US oil contract fell as low as minus $37.63 a barrel (yes, minus), meaning that holders were effectively paying others to take their oil away. This clearly needs some explaining. Is this new evidence that global demand is in freefall? And what do lower oil prices mean for the world economy anyway?

It’s important to understand that there’s no such thing as a single global ‘oil price’. Instead, there is a wide variety of different benchmarks and contracts, which are differentiated according to three main characteristics: the quality of the oil, its location, and the timing of its delivery.

For example, in the US the main crude benchmark is West Texas Intermediate (WTI), which is a relatively light and sweet crude (that is, low density and low sulphur content), and therefore easier to turn into useable fuel. Elsewhere, it is more common to take North Sea Brent as the benchmark. Brent is not quite as light and sweet as WTI, which once meant that it was cheaper.

Location is also crucial. For historical reasons the trading hub for WTI is the tiny town of Cushing – in landlocked Oklahoma. If you buy oil using a WTI contract on the New York exchange, this is where it will be delivered. That’s convenient for some US markets, but not for global traders.

What’s more, the surge in shale production (thanks to fracking) has increased the supply of US oil and gas. This has put downward pressure on the price of WTI relative to Brent and, given the difficulty of physically arbitraging between the two markets, means that Brent is now more expensive.

The third characteristic – and the one that’s making all the difference here – is timing. The oil price that turned sharply negative on Monday was the May contract for WTI, which is expiring today (Tuesday). This means that anyone left holding one of these contracts will have to accept physical delivery of 1,000 barrels for each contract in May – at Cushing.

That might not be a problem, if there was ample demand for oil from end users, or at least if there were plenty of storage capacity to hold the oil until demand does pick up. But unfortunately for holders of the May contract, neither is true. The coronavirus slump means that demand has collapsed, while the tanks at Cushing are already nearly full.

As result, owners of the May contract essentially had to dump their oil at any price – even a negative one. It’s worth noting that has happened before (albeit not to WTI). The price of North Dakota crude briefly turned negative a few years ago. It is also relatively common for the wholesale prices of US natural gas and electricity to turn negative when supply and demand are out of sync.

Of course, an oil price of minus $37.63 is exceptionally low by any standards, but it is an anomaly. On Monday the June WTI contract was still trading at around (plus!) $20 per barrel. And Brent for June delivery was still priced at around $25, which is pretty much where it was a month ago. In other words, the bigger picture is much the same as it has been for a while.

It is possible that these prices will also fall further. For what it’s worth, my guess is that they will remain firmly positive, both because the global lockdown should be easing in a month’s time and because cuts in global oil production should be kicking in by then. But even at current levels, oil prices are much lower than before the coronavirus outbreak became a global pandemic. WTI and Brent began the year at around $60 to $65 per barrel.

So, what does this all mean for the world economy? Monday’s wild swings are not new evidence of a meltdown. Indeed, a fall in oil prices is usually good for global growth. This is because oil consumers tend to be poorer than oil producers, so they are likely to increase their spending on other goods and services by more than producers are likely to reduce theirs. Typically, a $10 fall in the price of a barrel of oil might be expected to boost global GDP by around 0.2%.

Unfortunately, the larger the fall in the oil price, the bigger the risk that the negatives outweigh the positives. Many oil producers, rather than just see their incomes fall a little, may be driven out of business altogether. This is a particular problem for relatively high-cost US producers – and for the financial institutions who lend to them. At the very least, oil producers are likely to reduce their own investment and workforces, which could be game changer for some oil-dependent economies

What’s more, the reason for the fall in oil prices matters too. In this case, the coronavirus crisis is primarily a demand shock affecting the whole economy, meaning that consumers may be unwilling (or unable) to spend any savings on their fuel bills on other goods and services.

Nonetheless, as long as the contagion from the financial problems faced by marginal oil producers can be limited, the fall in oil prices should still help the global economy to recover, once the emergency restrictions are lifted. So, on balance, lower oil prices are still a good thing. (There’s a separate debate to be had about the environmental impact, but that’s for another day.)

In the meantime, if you are watching the financial markets for clues about the economic outlook, it probably makes more sense to look at equities. The time horizons of stock market investors are typically much longer than those of speculators taking a punt on next month’s oil price. Encouragingly, the main US stock market index (the S&P 500) has risen by around a quarter from its March low. Other major indices in the rest of the world have also seen significant (albeit smaller) gains.

Finally, if you do want to focus on oil, pick a more reliable benchmark. I hope it’s more than just crude British jingoism to suggest that this should be Brent!

This piece was first published by CapX

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