Those income seeking investors who moved into oil stocks after banks cancelled their dividend payments will be dismayed to hear that the oil price hit minus $40 a barrel recently, meaning that the oil producer has to pay the recipient to take delivery of the commodity. Oil traders familiar with terms such as contango, when the oil’s futures price is higher than the spot price and its reverse backwardation, where the futures price is lower than the spot price, will be less concerned. This is why.
The world typically uses 100 million barrels of oil a day. By mid-February there was a reduction in demand by 7-8 million barrels a day driven by a reduction in airline usage, which typically use around 6 million barrels a day. The reduction of oil demand was further heightened by China entering into lockdown following the breakout of COVID-19.
More recently the International Energy Association (IEA) which puts out its authoritative oil market report has stated in Q2 of this year there will be a 25 million barrel per day reduction. The IEA said the oil market would recover 10 million barrels by Q3 and by Q4 probably back to using 95 million barrels a day.
Adding fuel to the fire was a spat between Saudi Arabia and Russia who continued to supply oil at their existing levels creating a price war. This has thankfully been resolved although the issue of too much oil being produced with not enough storage capacity remained.
The point is that the negative oil pricing that has been hitting the headlines is for Western Texas Intermediate (WTI) oil and not Brent crude. This is because WTI has to be physically settled, with buyers having to take possession of the oil they owned at a date specified in a contract. However, given that Texas is a landlocked US state with limited storage capacity, paper speculation was around 20-times the amount of those genuinely intending to take delivery of the oil. Those speculators weren’t really in a position to do much about this as the contracts expire on one particular day of the month. Those able to take physical settlement knew this hence the stark pricing anomaly, with those delivering oil having to pay recipients to take the commodity from them. A bizarre almost Orwellian concept.
The collapse in oil prices has had implications for the commodities market as a whole. Many commentators have predicted that shale oil producers are likely to leave the industry as many have high production costs and the cost of capital for shale will increase as this capacity won’t come back fast. This may also have an impact on some US banks who lent to these companies as the risk of default may increase drastically.
Furthermore much has been said of the move away from hydrocarbon products by oil majors as oil is becoming reminiscent of the tobacco sector in the closing decades of the 20th century, with large institutional investors selling their holdings in the growingly unpopular industry.
With the rise in environmental, social and governance investing continuing unabated, investors holding oil majors may take this bizarre pricing pattern as a bad omen for the future of the industry.
