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What the Oil Price Collapse Means

What the Oil Price Collapse Means

We marked an important step on the road to Making America Great Again on Monday when the price of US oil for May delivery went negative. At the end of the day’s trading, producers were paying more than $37 a barrel to anyone who would take their oil. June contracts are now trading in the teens. A commodity that’s been priced around $60 is on its way to single digits. What happened?

Three headline events have dictated the narrative. On March 7, Saudi Arabia announced massive price cuts and production increases, ostensibly aimed at muscling Russia back into a production deal with OPEC. Second of course is the series of lockdowns imposed in Europe and North America that decreased energy demand. Finally, the brief dip into negative pricing is explained by the sudden need to store a lot of oil that no one wants.

These three events aren’t quite enough to explain the historical collapse in oil prices and come nowhere near explaining how a commodity could register a negative market price. The Saudis backed off their production hike, with a few asterisks, a few weeks later after reaching an agreement with the Russians. And consumption hasn’t declined as much as one might imagine. To date, oil consumption appears to be down, at least for the moment, by about 25%. That’s a lot of decrease to absorb quickly, but not enough by itself to justify a 75% price decline or negative pricing.

We get closer to the real story by examining the storage crisis. This reckoning has been years in the making, as oil demand increasingly detached from economic growth. When storage of unused surplus is one of the hottest businesses in a particular industry, you should know that trouble lies over the horizon. A long term decline in the oil industry has hit a crisis point. The structure of the industry in Texas, and consistently inept leadership in Washington, will contribute to its demise.

Almost everywhere else in the world, minerals belong to the state. Big global producers like Saudi Arabia, Russia, Mexico and Venezuela manage their oil industry through state-owned companies. They can centrally control their production levels, making it possible to enter international deals through organizations like OPEC to manage supply and protect industry profits from market swings.

Oil production in the US has no such throttle. We have no national entity to manage our oil production and no means through which to influence output. The legal framework around oil production in Texas, which dominates the US industry, severely punishes any restraint in pumping.

Under Texas law, an oil lease lasts as long as the lessor keeps pumping. When production on a lease is “shut in,” the company that bought the lease loses their rights to the oil. A shut in also triggers expensive obligations to cap the well.

Mineral owners and producers are punished for throttling production through other means as well. Texas mineral owners do not exactly “own” the oil under their land. What they own is the right to exploit reserves under their land. It’s very rare that an underground oil reserve is entirely contained beneath a single owner’s land. If one owner limits or stops production, a neighbor sitting above the same reserve can continue to pump, effectively sucking future profits from landowners around them with no constraint. Everyone has a structured incentive to maintain maximum production regardless of market conditions.

Shutting down a well safely and responsibly is costly, but that’s not the only problem with losing a lease. Financing for new oil exploration in recent years has been heavily leveraged. Much new production has been collateralized based on the producers’ “proven reserves,” assembled across a collection of leases. Shutting down enough of those leases for whatever reason will trigger an uncomfortable phone call from your bank, or more likely your hedge fund investors, seeking to recover their money.

Oil prices influence US oil production almost exclusively by impacting exploration, rather than production. Once a well is drilled, there is no central authority that can help producers reach production agreements. Apart from potential bankruptcies of producers, there is little force available to contain production.

This legal and economic framework was devised in a world in which oil demand seemed limitless. We don’t live in that world anymore.

Fossil fuel demand has been increasingly decoupled from global growth for almost 20 years, with demand relatively flat over the recent economic boom. Annual growth in oil demand has lagged GDP growth every year except 2010 for more than a decade. Growth in demand for oil had declined to zero last year and was headed negative before the recent crash. Amazon and Microsoft simply use less oil per dollar of revenue than the big industrial companies of previous generations. Plus, many of the world’s largest economic drivers like Apple and Google have moved almost exclusively to net-renewable energy use. The monster that ate the coal business was taking chunks out of big oil before this crisis arrived.

What’s been growing in the US oil industry is the business of storing unused product. For years we’ve seen story after story about the massive scramble to add storage capacity. When the crisis finally hit, the problem wasn’t that no one had been adding storage capacity. The problem was that the massive increases in storage capacity over the past decade hadn’t kept pace with faltering demand and unrelenting production.

Before COVID-19, and before the Saudi power move, oilfield bankruptcies spiked in 2019 as these heavily leveraged producers confronted stagnant demand despite a booming economy. Even before the pandemic, one analyst predicted that 2020 would be “The Year of the Oil Bankruptcies.” Producers were simply losing their race against a declining market, with stockpiles filling up available storage.

In theory, the Texas Railroad Commission, responsible for regulating the oil industry in Texas, has the power to limit production. In reality, they don’t. The TRC has the legal authority to impose “proration,” forcing producers to limit production to a percentage of their earlier levels. In practice though they lack the data on which to base those decisions, a bureaucracy to promulgate those rules, or any of the necessary governing infrastructure required to enforce any limits. Texas runs a government small enough to “drown in a bathtub,” which means that government is too weak to rescue an industry in crisis.

How does a commodity crash so hard that it briefly forces to producers to pay people to take its product? A crisis doesn’t do that. When a poorly built levy breaks, everyone blames the flood. The oil business in the US is not going to recover from this crisis, just like it failed to bounce back from the last one. Oil is dying from falling demand and ideological blindness. If oil industry workers want to know what’s coming for them, they should ask a coal miner.


    1. Aaron, there are videos all over the Net with these armed terrorists screaming at state cops, who were the only thing stopping these psychopaths from attacking some people (dem’s) in the legislature.

      But you keep on believing that this will all go away without any violence. The tyrant either “wins” the election, or there is civil war. Take your pick.

      Actually, the point is moot. I have stated it before. The results of the election are already established. Florida is not flipping. Neither is Wisconsin, nor Arizona. The tally of the votes will state that, regardless of what the actual numbers are.

      The u.s. is now a failed state controlled by a madman and his cult . No one wants to say it, but those are the facts.

  1. Hi Chris, I’ve been meaning to say something about Covid but I’ll wait for a post where it’s germane since I’m late to the party 🙂

    WRT the oil market, you’re correct about the broad swing away from fossil fuels, but the current turmoil has much to do with the bigger cancer of financialization of the economy. The FIRE industry (finance, insurance, real estate) is a giant parasite on the rest of the productive economy, and oil has now become their casualty. IOW, everything Goldman Sachs touches dies (but not before the vampire squid sucks the life out of it).

    Let’s start with why oil has boomed in the US to begin with, despite our actual demand not increasing all that much (as you point out). Fracking is not a new technology. It’s been known for decades, but it was never financially profitable, so no one bothered. Here’s the shocker: despite higher prices and improved technology, it still isn’t. The only reason frackers exist is because, thanks to the Federal Reserve funnelling trillions of dollars into Wall St. and artificially depressing interest rates to help blow massive asset bubbles, frackers can get cheap debt, with their junk bonds requiring lower interest rates than AAA-rated Federal treasuries used to command before the 2008 financial crisis.

    In the setting of cheap, massive Fed flows, and hedge funds / banks knowing that they’ll be bailed out no matter what, it’s not a surprise that trillions have been misallocated into blatently uneconomic activities, of which fracking is just one.

    Fracking has been accurately described as a fight between Saudi Arabia and the Fed: how much of a decline in revenue can the Saudis sustain to bankrupt the frackers, vs how much free money / bad debt bailouts is the Fed willing to throw at the frackers to keep such an unprofitable activity alive. So far, the Fed has been winning.

    Given that the entire industry is now dependent not on normal profit/loss calculations but on the whims of the finance world, it’s not surprising that when finance sneezes, even mighty Big Oil catches a flu.

    So what happened specifically last week? First, you have to realize that the futures markets which set the prices of those contracts have been completely taken over by financiers. Commodity futures were first created to allow actual buyers and producers to contract with each other and thereby allow them to have more predictable prices. For example, if you’re a refiner, you can buy contracts for one year out, thereby locking in the price of your raw materials, which allows you to plan your budgets for the year without depending on the whims of the day-to-day spot market. Similarly, a producer can sell futures contracts, which allows him to lock in prices that help him hedge against any price moves.

    This was the economic purpose that futures contracts serve: to allow actual producers and consumers of a commodity (whether it’s oil, wheat, or pork bellies) to hedge their pricing uncertainty and thereby allow for better long-term planning and certainty. To the extent that speculators participated, it was on the margins, and provided some extra liquidity to absorb risk in exchange for some profits.

    Unfortunately, these markets have been taken over by financiers. >90% of all WTI (oil) futures contracts are now executed by traders with *no* actual production or consumption needs. Which means the tail is now wagging the dog: the price is set by the financiers, and has as much to do with financial considerations (such as the price of storage, arbitrage with other oil contracts like Brent, credit costs, etc. not to mention
    completely non-oil related concerns like overall financial flows, how much commodity “exposure” a specific trading strategy wants, etc.) as it does with actual supply/demand of oil.

    In a great bit of schadenfreude however, this is one time when the traders got caught with their pants down. Oil futures, being intended for actual users of oil, are settled by physical delivery, not cash. That means, if you’re left holding a contract when it expires, you will receive 1000 barrels of oil in Cushing, OK. And you are contractually obligated to receive it. If you’re a desk jockey in NYC, and not an actual refinery / pipeline / storage operator, that’s not something you can handle. Normally, you get rid of this obligation by rolling the contract: before the May contract expires, you sell it, and buy the June contract. And in a normal market, you’ll always find some refinery willing to take on some additional oil at a good price. But the speed and size of the demand destruction means that *no one* who actually uses the stuff needs it right now. And so all of those traders (who hold 90% of the contracts on any given day) essentially had their bluff called, and were staring at 1000 barrels of light sweet crude being dropped on their heads, and had to exit their positions at any price or face huge penalties for breaking their contract. Which in this case, meant literally paying refineries and storage owners to take the oil they were speculating on.

    Puts a smile on a socialist’s face when capitalism works as intended 🙂 But this is merely winning one small battle while losing the war: this whole tail-wagging-the-dog story as the finance industry takes over entire industries and tailors their businesses to maximize financial profit extraction at the expense of actual positive economic activity is ruining *every* part of our economy (including health, which is partly why our Covid response has been so poor). The longterm move away from fossil fuels is just a small part of the story for why our energy industry is so messed up.

  2. I’m really looking forward to Republicans being suddenly super concerned about debt levels and enforcing austerity if a Democratic Senate or Presidency or both take over after all these trillions funneled into those poor defenseless corporations and oil companies.

    1. McConnell’s already starting to pivot in that direction, but I’m more interested in how increasingly aggressive Biden’s being. For a supposed moderate, he’s been ditching the genteel bipartisan shtick that he wore during the primaries and now he’s talking more like Elizabeth Warren (not a bad thing at all!). Perhaps he senses the generational opportunity that may be coming his way in November better than some thought?

      Tbs, it all depends on running a near perfect game in the Senate (winning in states like MT, IA, and GA) and doing away with the filibuster. With an economic depression on the horizon and double-digit unemployment though, it’s not unthinkable.

    2. Yeah, one of those “But, I’m not going to hold my breath “, observations… Afraid it’s “baked in” with the majority of republicans, but, as Ryan notes, financial calamity and 50k+ deaths have the potential to poke the conscience of otherwise disengaged and disillusioned folks. Key is whether Biden can motivational enough to provoke just enough indignation to get the job done. And, since McConnell has clearly broadcast his intentions to do a repeat of his Obama blockade, the win must be sweeping.
      I would suggest that even with a sweeping win of Congress and the presidency, there is one more major step needed. SCOTUS must be altered, in its composition. This will require increasing the size of the court and the political balance within it.

      Even with all these changes, the fact remains that the incoming government will have an incredible financial and structural challenge to manage. This is going to require a much stronger spine than Democrats have typically demonstrated. They will need to plot their own course and ignore the taunts by conservatives to be fiscally prudent – a canard that has been on full view, not only with Republican members of Congress, but also their major donors. IOW, Democrats, including Biden, will have to ignore the conservative rapprochement machine and plow ahead.

      The American people also have to take responsibility. This article which originally appeared in Business Insider, says it well. We all have to accept some unpleasant truths.

  3. Houston’s put out their Climate Action Plan on Earth Day, so it seems like we’re already planning for an oil-free future. It would’ve been nice to see this put out a few years earlier, so we’d have some preparation before this massive oil crash, but I’m interested to see how well it goes over the coming years:

    The most important thing with this current crash and the inevitable slow decay of the oil industry is to ensure that everyone employed by the it is capable of transitioning to a well-paying job, and that they’re supported. It’s highly likely that we’ll still need some petroleum for the manufacturing of certain plastics and materials until we can find alternatives, but the whole fuel sector of the industry is due to go away in the years to come, and the people who get laid off are going to need help.

    Unemployment assistance and job training that enables them to re-enter the workforce at a rapid pace is a must. I’ve said this before, but the culture around education, employment qualifications, and job training in the U.S. needs to shift. College degrees can’t be seen as the end-all be-all; two-year technical certification courses in certain fields, as well as apprenticeships, need to be brought to the fore in a way that we’ve never seen. Employers need to stop it with the degree inflation, as well as partially invest in the training of their own workers.

    1. You’re on target but I am concerned that there will be funding for this purpose. In America, McConnell has already drawn a hard line regarding further stimulus. Local and state governments can’t “print money” lije the federal government can. I believe there will be many societal and workplace changes ahead. Nations that focus on positive outcomes will lead the world. Greed and ignorance will trip up the rest.

  4. Remember how several times how I suggested that the sudden and final end of this presidency was the best option, and I was overwhelmed by how that was the worst case scenario….the tyrant is now suggesting firing up UV light under the skin or using some kind of ingested bleaching agent imight be a good idea to test out……yeah, the worst case scenario is here, even before November.

    Sorry folks, but there is no scenario worse than allowing the madman and his regime to continue.

      1. Look you know my position on this virus. But that being said, I am still clearly in the minority.

        Now imagine you are some 60 year old man, with underlying health conditions. If you get this virus, you will likely die. Then tack on you are black, and struggling financially. Your employer owns a small retail store (yeah, I know, does not exist). He says “Back to work you come, the president says its OK. Oh, BTW, I will be staying at home, managing remotely. But I need you in there. If you don’t go, I will fire you.” You have no other real options.

        And because of the tyrant’s resistance to reality, you are going back to a high contact location with little or no testing.

        It is one thing for me to say I am willing to risk it, since I am still in a what I consider low risk demographic. It is quite another for some guy who is in a high risk category to be forced back to work with little hope of testing and mitigation, thanks to an insane person running the country.

  5. The coal industry is getting hit as well. Coal generated power apparently down 36% YTY in March, with stockpiles running out of storage space as well. This SA article points out an interesting interplay with the oil/gas/fracking problem. As fracking slows, natural gas prices will rise, increasing future demand for coal, but if financing is not there for coal mines which shut down, then they can’t respond.

    I for one will not be sad if Murray Energy gets liquidated, and Trumpista Robert Murray loses his coal assets…. I’m sure he’s extracted more than enough to take care of his descendants. If that’s what it takes to help slow down coal burning then so be it.

    1. 1) developing countries, particularly China, are not adopting a car-centric urban development model.
      2) developing countries rejected our idiotic dependence on air travel, choosing instead to build robust rail infrastructure.
      3) Cars and airplanes account for 3/4 of all oil consumption. As the global economy’s center of gravity switches east, demand for oil declines.
      4) The most oil-intensive industrial activities are declining in the old developed world. Amazon and Netflix don’t use much oil per dollar of revenue compared to old manufacturing and industrial giants.
      5) The biggest, richest, most influential companies in the emerging economy are also ridding themselves of fossil fuel dependence, further feeding an innovation pipeline around renewable energy.
      6) Tesla is worth double the total market capitalization of the big three US automakers combined, and headed higher.
      7) Volkswagen has already announced it’s ending production of oil-based vehicles by 2026.
      8) China has committed to having 80m electric vehicles on the road by 2030, which basically decimates available capital investment for internal combustion producers.
      9) Global per capital oil consumption peaked around 1973, as developed countries began implementing tighter and tighter efficiency standards. It’s been declining since. Consumption began a fairly steep per capital decline in the US around ’04.
      10) Tesla has been the #1 selling luxury car in the US for many years, with no one coming close anymore. When Tesla releases their $25K version in about 18mos it will be lights-out for the US car industry. Don’t forget, computers used to be a luxury item too. Remember when everyone used to own a camera?

  6. Chris, all the global market forces you have detailed are of course accurate. But you are leaving out the biggest factor of all. The immense power the oil industry wields over politicians at every level will be brought to bear to prop up the industry on a massive scale.

    Tariffs on imported oil to create an artificial price will be as given. Yes, I am aware of what that means downstream in global competitiveness in so many other industries. That factor, while certainly not irrelevant, will pale against the lobbying might of the oil industry.

    You think bailouts for the farming and coal industries are something. Watch the work that will be done for the oil folks. War on Venezuela to reduce that all ready hugely diminished supply to zero is just one of many things that would be considered. And of course, Iran’s global supply must be stopped by more than sanctions. And let’s not forget the attacks on the green energy movement.

    Market forces are not the most powerful forces out there, at least in the short and medium term.

    1. Oh, that’s the best part. Those jerks bet on Donald Trump and he’s absolutely screwing them. Turns out, he doesn’t need Texas oil money donors or Texas voters as much as he needs a line of credit from MBS. So he’s made all kinds of promises to the industry and failed to deliver every time. And now it’s too late to matter.

      1. As the tyrant says, “we will have to see what happens”.
        WTI is back to 16.83 today, Brent Crude 22.41
        WTI June futures are at 17 , July futures 21, Aug futures 25.

        A lot can happen between now and Aug, but the trend is up.

        What is the breakeven point for some fracker in the Dakota’s? I have no clue. But I am positive that the tyrant will not forsake his base, at least not until the “election” is over. That being said, any serious oil state outside of Pennsylvania is already in the bag (his crew has already done the math, and know it is a done deal even with Penn flipping), so maybe he can forsake them. I just don’t see it happening.

      2. 16 is down 75% from last month. And it will collapse at the end of the contract month when there is still no place for storage. Right now traders are just playing hot potato with delivery contracts. No help is coming.

  7. Oklahoma is already citing a tax receipts failure and preparing for big cuts in next year’s budget.

    I assume these results are quarterly tax receipts which illustrates your point Chris, this economic train wreck has been enroute for a while. Texas has no state income tax and modest sales tax. Oklahoma has about a 5.25% income tax and very modest property and sales taxes. All either state has to cut is education, health and infrastructure. They are getting into a race Mississippi has already won.

    1. Not just Texas, although it’s absolutely going to take an economic knife in the heart from this. Oklahoma, Wyoming, North Dakota, Louisiana and Alaska all have sizable portions of their household earnings come from the oil and gas industry.

      Between the corona virus and the collapse of the oil industry, these states are going to need more than McConnell’s talk of “letting states declare bankruptcy”. We may find ourselves in the unenviable position of the federal government having to bail out multiple states or ensuring localized depressions all across the country.

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