A Historic Day for Big Oil
As the demand for non-essential services comes to a near halt due to the current COVID-19 pandemic, one industry that is acutely suffering is the oil industry. Due to strict lockdowns imposed by governments around the world, demand for oil has plummeted, and for the first time ever, this industry is experiencing negative oil prices. For a commodity that has for the most part has witnessed a trend increase in price since the industrial revolution, and one we deem crucial to our daily lives, this comes as a large shock with profound implications worldwide.
To begin, let’s consider two of the largest crude oil indexes. Both West Texas Intermediate, the US index for oil, and Brent, the international index, are trading at prices 60-80% lower than at the start of the year. West Texas Intermediate traded a barrel of oil for as low as $-40.32 at the start of the last week of April. This was considered one of the largest drops in prices ever seen. These negative prices suggest that some suppliers were in fact willing to pay households and firms to buy the oil from them. Furthermore, Brent recorded oil prices to be lower than $16 a barrel, a fall from $63 a barrel in early January, indicating the lowest prices since 1999 .
In order to deal with the falling demand, the OPEC cartel has agreed to cut down production by nearly 10 million barrels per day for the months of May and June, thus reducing the global oil supply. However, many argue that this cut will not be nearly enough to counter the drastic fall in the consumption of oil. In fact, an analyst from Ursa Space Systems heavily involved in finding storage spaces for excess oil claimed that even though supply has been cut by “historic amounts” these are still “a fraction of the decline in demand.”
The next question that arises is that if these cuts are not enough to match the fall in demand, then why not simply cut supply further? The answer to this question lies in the nature of the oil rigs. According to Tedore Cowie, an analyst with Rystad Energy, "Shutting-in production is a very painful decision for an operator to make." This is because once an oil well is closed, it is a very difficult process to re-open; therefore, closing an oil well for a short period of time effectively means closing it forever. Cowie argues that because of this property of oil rigs, “often the economics support running an oil well at a loss for a certain period of time rather than shutting down the project completely". As long as prices are positive, oil suppliers are making some money that they can use to cover their fixed costs. However, the current negative prices may be an indication that these oil wells do need to be closed to deal with the extraordinary shortage in demand.
Since oil suppliers cannot just shut off production without future consequences, and they are unable to sell it right now, their only option is to store the excess oil. Right now, there are around 3.2 billion barrels of oil in storage spaces around the world, highlighting another record as a result of the coronavirus pandemic . According to a source in Orbital Insight, the most common form of land-based storage is Floating Roof Tanks commonly known as FRT. The current world FRT storage capacity is still at 55.6% which can amount to around 2 billion more barrels of oil. While this may seem like a large number, the uncertainty of the current situation could cause this number to rapidly decrease in the near future, if demand continues to fall.
Apart from FRT storage facilities, other alternatives do exist. These include fixed roof tanks, salt caverns and even floating storage tankers at sea. While the latter option is more expensive, it is estimated that almost 160 million barrels may need to be stored in sea-based tankers. This suggests that suppliers are willing to look to more expensive forms of storage in order to prevent them from closing their oil wells or oil rigs.
Despite the issues outlined above, some companies and countries are managing to maintain their profits through a strategy called ‘hedging’. Mexico has used this strategy to maintain its ability to sell crude oil at high prices despite the global indexes dropping . In the oil industry, hedging is used to peg oil prices for a certain quantity of oil during a specific time period. If the index oil price falls below the pegged price, then the bank or other party would need to make up the difference. While this may seem like a great solution in these times of uncertainty, there is an evident risk as well. If oil prices increase, this would cause the suppliers to lose out.
However, in the current situation, hedging has worked in the favor of suppliers that have used it. According to Mexico’s president Andres Manuel Lopez Obrador, the country will earn up to $6.2 billion as a result of hedging, where they pegged the price of oil to $49 per barrel. Additionally, some North American producers have benefitted from this strategy by hedging heavily, locking oil prices as $52 per barrel. Unfortunately, companies that did not choose to invest in this strategy previously cannot benefit from now, as it would be difficult to engage any trader in agreeing to a hedging deal with the current state of uncertainty that the pandemic has caused.
With declining demand due to global lockdowns, the oil industry is doing everything it can to fight the effects of the pandemic. However, as a demand-driven industry, they may be defeated as the fall in demand overshadows all attempts to combat it. Fortunately, this means that the moment the world begins to recover from the pandemic we will see an immediate turn around for this industry. However, for now, as uncertainty in the spread of the virus and its effects continue to rise worldwide, the same can be said for the oil industry and oil prices, globally.
Written By Aditi Rudra, Undergraduate Economics Student
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