The Fuse

Oil Goes Negative. What Does it Mean?

by Nick Cunningham | April 21, 2020

The front-month WTI contract fell into negative territory on Monday, collapsing by 100 percent.

Cratering prices are largely an anomaly, related to the expiring contract for May. But the meltdown also reflects a ruinously oversupplied oil market. Storage is filling up amid collapsing demand as the global economy risks slipping into a depression.

Filling up and shutting down
The epic meltdown needs some context. The price is for May delivery, and traders have all but abandoned the contract, instead moving on to June numbers. The negative prices reflect traders trying to avoid getting stuck with physical delivery of oil cargoes next month. As a result, analysts cautioned that the numbers for WTI, which expire on Tuesday, are increasingly meaningless in terms of gauging the oil market. For instance, the WTI contract for June held up at around $22 per barrel – still disastrous for oil producers, but far from being literally worthless.

While oil falling below zero is a weird quirk of expiring contracts, the collapse is not without significance. The collapse of prices to zero reflects a physical market buckling under oversupply. If prices fell below zero it would mean that producers would need to pay someone to take cargoes off of their hands.

More broadly, the sudden crunch is a symptom of several stages of the oil supply chain reacting too slowly to the collapse of demand. Global oil demand is down by roughly 29 million barrels per day (Mbd) in April, according to the IEA. That plunge in consumption happened virtually overnight.

After some delay, refiners have ultimately made substantial cuts, on the order of 3 Mbd in the United States, for example. But upstream producers have also been slow to react. Instead, they kept producing and funneled oil into storage. “Just like refiners, who have a delayed reaction to soft downstream demand, oil producers have responded slowly to changes in refining demand,” Bank of America Merrill Lynch said in a note. “The need to push oil into storage and for production shut-ins has resulted in depressed spot prices and a steep contango.”

Between mid-February and early April, crude oil inventories rose by around 200 million barrels, according to Bank of America, a figure that excludes refined product stocks. Rapidly filling storage has depressed prices and has begun to force shut ins at the well head.

“As storage fills up, countries are being forced to shut-in production on a large scale to counteract a theoretical oversupply of 21 million bpd in 2Q20,” Rystad Energy Senior Oil Market Analyst Teodora Cowie said in a statement. “Shutting-in production is a very painful decision for an operator to make – often the economics support running a well at a loss for a certain period of time rather than shutting down the project completely. But with infrastructure constraints, this is no longer an option for many landlocked producers.” Globally, around 1.9 Mbd of oil production has already been shut in in April, according to Rystad Energy.

Canada has been hit with shut ins first, but U.S. shale shut ins are also underway. “If all producers stopped bringing wells online after March, L-48 onshore crude oil output would fall by 1.5mn b/d by June-end, with more than 700k b/d of supply lost in the Permian,” Bank of America said. “While it is difficult to determine how quickly supply will fall, we think the combination of US and Canadian supply curtailments should help slow stock builds in the US until refining recovers.”

The investment bank sees U.S. oil production falling by 1.4 Mbd by the fourth quarter, which may yet prove to be an overly sanguine assessment.

Demand hit could persist
The global pandemic could stubbornly drag on, threatening to impose the worst economic downturn in a century. Oil demand is down by 25 to 30 Mbd in April. While demand destruction may be less severe in the months ahead, there is vanishingly little evidence to suggest that global demand will return to pre-COVID-19 levels anytime soon.

In the face of a persistent downturn, the OPEC+ cuts – an estimated 9.7 Mbd for two months – may wind up being both insufficient and hard to police. “OPEC+’s record cut is no match for an unprecedented demand drop,” Morgan Stanley wrote in a note on April 17.

Meanwhile, Reuters reports that there is still a bit of a battle for market share between Saudi Arabia and Russia, a warning sign that the OPEC+ coalition could face cohesion problems.

The next thing to watch out for is bankruptcies and supply shut ins. “If these materialize in the next month, then we can begin discussing optimism in June, but right now, given the likely low compliance of OPEC+ cuts by May 1, the optimism is not yet warranted, and we could see a repeat situation next month,” Rystad Energy said in a statement.