The mystery of oil at -$37 per barrel, and what to expect for June contracts

Getting past the crazy historical anomaly of May oil contracts trading at -$37, the reality remains simple and cruel: oil at $20 per barrel is still too low for many companies to survive for a sustained period of time

Scott McKnight - April 20th 2020

The price of futures contracts for the US benchmark crude, West Texas Intermediate (WTI), crashed through zero to close at negative $37 per barrel. In other words, traders with physical barrels of oil to sell found themselves paying others to take it off their hands. This outcome is bizarre and unprecedented, but also needs clarification.

Prices went negative because the physical market in Texas and Oklahoma, two states that receive much of the crude oil in the United States and Canada, is inundated with barrels that neither traders nor refiners wanting it. But the US isn’t alone in running out of storage space. Pemex, Mexico’s national oil company, has a glut of gasoline and no place to store it.  

This ‘weird one-off glitch’, according to oil journalist, also helps explain huge differentials in crude prices (there are a myriad of oil qualities or ‘grades’), with some grades already at or near negative prices last week. For example, customers were bidding to pay barely $4 per barrel for Upper Texas Gulf Coast and only $2 per barrel for South Texas Sour last week.

Putting May behind us

Let’s put the headline-grabbing and head-scratching negative price of the May contracts behind us. The June contracts may help us understand where the market is heading. Trading at about $20 per barrel on Monday, the June futures contracts show that we’re still in dangerous territory for many of the world’s producers, especially for the myriad private and publicly traded companies with relatively high-cost producing wells in North America.

The Easter agreement between the oil-exporting countries of OPEC, so-called ‘plus’ countries led by Russia, as well as several large and mid-tier oil-producing countries of the G20 collectively agreed to make cuts to production. The agreement was historic but—as WTI’s closing in negative prices Monday showed us—has yet to impact the physical market. And, unless emergency measures are taken, the deal won’t take hold in May either.

The supply side remains messy, if not downright ugly. The effects of the price war, most notably when Saudi Aramco ramped up to produce at maximum capacity for about a month preceding the Easter agreement, is still playing itself out in the physical market. In other words, that excess of crude is currently on tankers, in terminals or in storage, only adding to a market that is already thoroughly oversupplied. With this supply overhang and storage access in the US as elsewhere quickly reaching its limits, there is still no sign of relief on the demand side—from commuters, airlines, ships and factories—to bite into this surplus.

The second quarter of 2020 will ‘likely be the most uncertain and disruptive quarter that the industry has ever seen’

Olivier Le Peuch, CEO of Schlumberger, a service providing behemoth

There are broader worries extending into the mid-term horizon, too. The Easter weekend deal, even if naively taken at face value, is still not enough to prevent the oil market from being completely overwhelmed by an unprecedented glut of oil. The pending cuts are inflated and now more than ever vulnerable to cheating from any—or all—producing countries as each is desperate for revenue and unable to resist the free-riding urge amid this economic crisis. Even in a best-case scenario of extreme discipline and commitment among the signatory countries, these cuts of just under 10m bpd only amount to about one-third of that 29m bpd loss in oil demand.

The Cuts and the Pain

Oil prices in the United States and Canada are at their lowest levels since early 1999. Firms across the industry and in virtually every segment—upstream as well as downstream—have been cutting spending over the past weeks in anticipation of this pain.

For example, shale companies in the United States, the vast majority of whom do little else but ‘frack’ for oil, while leaving the shipping, refining and retailing to others, are among the most vulnerable in this price environment. As such, they’ve collectively cut more than $29bn in spending, with more no doubt pending.

It’s not better—and actually worse—for the service giants that are vital to getting the oil out of the ground. Halliburton, a giant in the industry that provides equipment and services to energy companies, reported a $1bn loss in the first quarter of this year. It also announced a sharp reduction in capital outlays to a mere $800m, one-third lower than its previous guidance and even lower than its spending in 2016 following the last oil price crash.

In Canada, an infamously high-cost producer and home to the ugly stepchild of crudes, West Canada Select (WCS), has been trading under $10 per barrel for nearly two weeks. This has forced firms in Canada’s oil sands to shut in production. Further cuts in the oil sands may eventually amount to the most extreme and extensive in the global oil industry. Altogether, oil production in Western Canada could be reduced by one-fifth or one-fourth of its 2019 levels; in other words, Canadian oil production could fall 1.1 to 1.7m bpd, a massive blow to the province of Alberta where much of this oil is produced.

All throughout the oil sands, the pattern is similar. Husky Energy reduced its oil sands production by 15,000 bpd and its capital expenditures by $700m. This comes after the company had already slashed $1bn in spending since early March. Crescent Point Energy said it will shut in 70% of its production, citing low prices. The company also cut capex by another $75m, adding to the $400m in cuts announced last month. Cenovus, another company in the oil sands, reduced output by 45,000 bpd with the possibility of another 100,000 bpd in cuts. Last week, ConocoPhillips said it would cut its oil sands output by as much as 100,000 bpd.

Low prices make production of this high-cost heavy oil from bitumen reservoirs simply uneconomical. An added problem is the nature of the steam-driven oil sands production projects themselves, which in some cases may be permanently damaged by the shut-ins, unlike the more conventional wells that can be reopened when prices rebound.

Keep your hands inside the vehicle

The wave of shut-ins, bankruptcies and belt-tightening may set the stage for a nice rebound when the lockdowns lift and economies gnaw away at this excess supply. In the meantime, however, several billion people, some in the biggest and most oil-hungry economies of the world, remain under some form of lockdown. This is a reality that many of us understand intimately: our cars parked in the driveway and used sparingly, planes grounded or flying with minimal numbers of passengers, ships in ports awaiting cruisers and goods to transport. For the month of April, oil demand will be down by 29 million barrels per day (bpd), or about 30% of where oil demand was at the end of 2019.

The rebound is still far off. Indeed, there’s really no reason to think that $20 per barrel, where WTI future contracts for June have temporarily, is the bottom. Expect similar whiplashes in the June contracts as we saw in May’s. The Easter agreement, however flawed, will not be felt as the oil glut fattens in the coming weeks. The head of Schlumberger, another service providing behemoth, believes the second quarter will ‘likely be the most uncertain and disruptive quarter that the industry has ever seen’. This is saying something after the wild ride of the oil markets in March and April.