Before we proceed straight to the point, I bring here basics on crude oil and operations.
Global Oil Producers & Consumers
Major Oil producers: US (19%), Saudi Arabia (12%), Russia (11%), Canada, China, Iraq, UAE (19%)
Major Oil consumers: US (20%), China (14%), India, Japan, Russia (4% each), Saudi Arabia (3%)
Statistics for year 2019:
Total world Production = 100.57 mbpd
Total world Consumption = 100.75 mbpd
*mbpd - million barrels per day
Upstream & Downstream Oil operators
Companies in the oil and gas industry are usually divided into one of three groups - Upstream, Downstream, and Midstream
1. Upstream oil and gas companies are involved in exploration and production of crude oil /gas from through drilling. They identify the oil deposits, drill wells, and recover raw materials from underground. They are called Exploration and Production companies. This sector also includes related services such as rig operations, feasibility studies, machinery rental, and extraction of chemical supply.
2. Downstream companies are involved in buying raw crude oil from Upstream/Producers, refining of oil to create varied range of products like gasoline, diesel, petrochemicals etc. They are involved in the sale and distribution of finished products upto the point of sale. These are mainly Refiners.
3. Midstream links upstream and downstream and includes transportation and storage services.
About types of Crude
The most popular traded grades are Brent North Sea Crude (Brent Crude) West Texas Intermediate (WTI), Dubai Crude.
1. WTI is the benchmark crude for North America. The NYMEX (New York Mercantile Exchange) division of the CME (Chicago Mercantile Exchange) list futures contracts of WTI crude oil. Delivery for WTI crude futures occurs in Cushing, Oklahoma. WTI oil is extracted from wells in the U.S. and sent via pipeline to Cushing, Oklahoma. It is America’s key storage hub and delivery point of the West Texas Intermediate contract. These supplies are land-locked, which is one of the drawbacks, since it becomes relatively expensive to ship to certain parts of the globe. WTI continues to be the main benchmark for oil consumed in the United States. This is a lightest in the basket since it has least sulphur content.
2. Brent oil is produced in the Brent oil fields and other sites in the North Sea. Brent Crude's price is the benchmark for African, European, and Middle Eastern crude oil. Has higher sulphur content than WTI.
3. Dubai (Middle Eastern) crude is a reference for oil basket containing supplies from Dubai, Oman or Abu Dhabi. It is heavier and has higher sulphur content, thus lower grade than WTI & Brent. Dubai/Oman is the main reference for Persian Gulf oil delivered to the Asian market.
Pandemic Impact
Due to the pandemic and suppressed economic activity due to containment measures, as per reports, demand has reduced by around 25 mbpd i.e. 25% of global demand. When demand reduces, it become necessary to cut down the supply due to various factors like, Decrease demand with no supply cuts will cause oil prices to drop significantly. Oil prices below Break-Even point would bring producers on brink of bankruptcy. Also, higher production may lead to higher Inventory holding cost, which includes actual storage cost and working capital cost. Shortage of storage space also counts in.
As can be seen historically, producing countries are normally hesitant to cut the production and supplies. Few factors are given below:
1. Higher contribution of oil production to GDP for many countries like US, Middle East oil production.
2. Exploration of oil is a risky business and involved heavy investment before the drilling operations start. Capital investment involves for exploration blocks, rigs and factoring equipment. This is Sunk Cost. Reduced production shall suppress their revenue, turning major producers into loss making.
3. Heavy Lease charges are incurred for area where drilling operations are carried out. Recurring expenses like High lease charges, admin-maintenance costs are unavoidable in nature despite the cuts
4. High financing costs since majority of the projects are financed through debt.
5. Addition to unemployment since many jobs are also at risk.
Sharp rise in Energy Corporate Bond Yields
Indicating the increased risk in the energy companies, their bond yields have spiked. Increase in the yields suggest the underlying increased corporate risk. (Higher the bond yields, higher the risk and vice versa). Even, Bankers are increasingly reluctant to give commodity traders the credit to survive as lenders grow ever more fearful about the risk of a catastrophic default.
In April 2020, major oil producers have decided to cut down the oil production by 9.7 mbpd, which is around 10% of global production.
However, since the declaration, Spot prices for WTI (West Texas Intermediate) crude have dropped by massive 64% from 25$ to 9$ today. Brent Crude Spot, on the other side, fell down by 35% from 30$ to 20$ today.
Below is the Spot trend
Despite the cuts, prices have fallen indicating more production cuts shall require.
Monday Mania..
There is a lot of chaos going around when on Monday, May 2020 Futures contracts for WTI Crude tumbled into the negative territory. These contracts expire today, i.e 21st April 2020, Tuesday (2nd last Tuesday of previous month, delivered during the month) and are physically settled on expiry. Thus, market participants long on futures, have to take physical delivery on expiry of these contracts. (1 future contract = 1000 barrels)
High Inventories; Storage levels sprinting to brim
There is huge unused quantity of oil that the American companies are holding, and that they have run out of storage space. According to reports, Refiners are rejecting barrels at a historic pace and with U.S. storage levels are sprinting to the brim. Many refiners have bought large quantities of crude taking advantage of lower prices. Crude stockpiles at Cushing have jumped 48% to almost 55 million barrels since the end of February. The hub had working storage capacity of 76 million as of Sept. 30, according to the EIA. Since the demand for crude is seen muted owing to the measures taken for containment of pandemic, it is difficult to take physical delivery of crude.
Thus, to avoid taking physical deliveries, long position holders started dumping the contracts on Monday, thus squaring off their positions. Along with storage, others costs involved with Freight /Transportation, Insurance cost further chews away margins for refiners.
Thus, May 2020 contracts settled yesterday at $ -37.63 per barrel. However, today May contracts have recovered to $ -4.33 per bl and June contracts have not tumbled that far since demand is expected to take a pick in coming weeks. Contracts for June 2020 are highly active is trading at at $ 15.91 per barrel (IST 18:00)
Future View: The market sentiments are massively bearish. Negative oil prices point towards a deepening unseen global crisis. Once demand picks up, oil prices will see a recovery but may not come back to original levels. However, it is uncertain when this will happen.
Sources: EIA, Bloomberg, NYMEX, Investing.com
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