What happened to oil prices (20/04/2020)?
The Coronavirus has caused the world economy to grind to a halt, due to isolation during the current pandemic. As a consequence, May oil futures were trading at around -$40 a barrel. Theoretically, this means you are being paid $40 to receive a barrel of oil.
This is an unprecedented move in financial markets but why did it happen?
The last time we have seen an event like this is during 2011 (Arab Spring)
In April 2011, one of the largest oil storage facilities in the US, Cushing, became full due to US traders trading oil futures and taking delivery all at once. Cushing is a facility based in Oklahoma with a maximum capacity of around 42 million barrels and was essential for storing and distributing oil around the US. Normally, in the oil futures market 98% of the contracts being traded do not go for physical delivery, however, many US traders did take the delivery oil which caused Cushing to become full.
If an investor purchases a futures contract for delivery and the only storage location for the oil is full, we have major problems because there is nowhere to store the oil. In 2011, the price of US oil started to tick lower despite the tensions in the Middle East which would usually cause the price of oil to increase due to potential supply chain issues in the Middle East which is a prominent net exporting region of oil.
Contango Vs Backwardation
It is important to understand the difference between contango and backwardation when analysing commodity prices and why different commodity futures trade differently over time. In a normal commodity market where you have to look after a product and store a product, there is normally a cost of carry, which is the cost you would have to pay somebody if you wanted them to store the commodity for you.
For example, if I went to the market and opted to buy gold today, I could purchase this and incur the storing costs myself. If I went to the market to purchase gold for in 12-months’ time, the seller will incur the storage costs for 12-months and they will not do that for free. The seller will charge the cost of carry; therefore, the commodity price goes up the longer the cost of carry.
Oil is different to Gold!
Oil is considered a finite commodity with high demand, instead we have an inverted curve. There is a belief of high demand and finite supply, therefore, people are willing to pay more for oil now than in the future. Despite the seller incurring a cost of carry, the buyer does not care, they would prefer the in-demand product now.
A commodity in contango has a price relationship like the yellow line (normal) on figure 2 and the dark-blue line on figure 3. Figure 2 shows the impact of the cost of carry on the price of the commodity, whilst figure 3 is indicative of the futures price falling over time until we reach the spot price. The reason the futures price falls over time is because as the time to maturity of the contract decreases, the storage costs over that period will decrease, therefore, the cost of carry decreases. Logically, the cost of carry for a 12-month period will be higher than that of a 3-month period.
When we have a commodity in backwardation it has a price relationship of the blue (inverted) line on figure 2 and the light-blue line on figure 3. Figure 2 is indicative of the commodity being a finite resource with high demand, therefore, consumers of that commodity would prefer that good today and are willing to pay a higher price than in the future. Figure 3 shows the futures price moves higher over time until we converge to the spot price. The reason for the futures price increasing over time is because the futures contract signifies that we will have to wait until a period in the ‘future’ to receive the oil, when we would prefer it today. This means, a buyer would prefer to wait 3-months to receive the oil rather than 12-months, therefore, the contract with a time to maturity of 3-months is more expensive.
Oil is in backwardation! The closer we are to maturity the more expensive the futures contract. (Spot price is the price we can get oil for now, currently in the market).
Gold – futures are more expensive than at the spot price due to the cost of carry.
Oil – futures are cheaper than at the spot price due to oil being an in-demand finite resource.
How was the price of oil able to go negative?
The May futures contract traded at negative prices for the first time in history. This means oil producers would pay buyers around $40 to take the commodity of their hands due to storage capacity of oil nearing its capacity. As previously discussed, this was a similar but a more severe scenario to April 2011 as Cushing reached its capacity.
The coronavirus has crushed oil demand as the economic activities of many countries has dried up due to the restrictive measures in place to reduce the global impact of the virus. When the price went negative, the rate of delivering oil in the US was too high, this meant the tanks in the major storage locations would become full before the end of May. Consequently, the fear of storage locations nearing capacity, meant traders were willing to pay up to $40 to offload their May futures contracts to avoid having to take delivery of oil and incur the costs.
Impact on the US Shale industry
A simple impact on the US oil companies is that the companies are producers of oil, therefore, falling prices puts pressure on their margins, potentially leading to bankruptcy. Few US firms could withstand a prolonged oil price war due to their break even points requiring the price of oil to be above $40 per barrel. (Russia and Saudi have a break even point of roughly $15-$20 per barrel so they can withstand the price war.)
Furthermore, there is currently mass unemployment in the US, as 22 million people filed for unemployment claims in the last 4 weeks, according to the jobless claims data. Since the financial crisis, the US created 21.7 million new jobs. This means the job creation over a 10-year period has been completed wiped out in a space of a month! With oil prices at depressed rates this may only exacerbate the negative impact on the US economy.
Oil Futures Outlook
Oil futures prices are expected to be below $35 until 2021, which is below many break even points for US oil companies. The scenario in the US is so bad, many US oil producing firms cannot file for chapter 11 bankruptcy. Chapter 11 is where the company files for bankruptcy with the aim to reorganise the capital structure so debt holders would normally swap their debt for equity. Debt holders do not want the equity, due to the increased likelihood of bankruptcy and bond holders would have a higher claim on assets than an equity holder.
Opportunities in the US oil industry
Rattler Midstream, Callon Petroleum, Epsilon Energy, US Energy Corp, Evolution Petroleum corporation, Exxon Mobil Corporation, Chevron Corporation and Renewable Energy Group. (The top quintile of major oil producing firms in the US)
The firms listed have a strong EBITDA/Interest Coverage ratio in comparison to their smaller competitors which means they will likely survive, despite oil trading at low prices. This could lead to a potential opportunity for the larger players in the market as they could benefit from a potential fire sale of much smaller names which go bankrupt.