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.