Oil Prices Crash Landing On Hard Reality. But What’s Next?
When the black gold turns red, does a new normal await?
“So oil prices could go negative, what does it mean?” — That was the general reaction when a key segment of US oil trading collapsed back in April. West Texas Intermediate went into negative double-digits for the first time in history last month to as low as US$-40.32 a barrel as the May contracts neared expiration, offering a glimpse into how oversupplied the US oil market has become after being hit by the impact of full lockdowns and travel restrictions around the world.
In theory, crude oil generally reacts to the laws of supply and demand. When the demand is high, maintaining a low supply will keep the prices high. But the reality is way more complicated than that with geopolitics often coming into play, and price wars among the world’s biggest oil producers taking place often.
With COVID-19 having significantly impacted global demand for air traffic and consumer products, petrochemical manufacturers are unable to take physical crude deliveries as a result of record-low global consumption and supply chain disruptions.
“The transportation is down and the aviation industry is operating at its minimum capacity. The demands for finished petroleum products such as jet fuel in the global market have declined by almost 80 per cent of what it should have been,” said Pankaj Andleigh, independent oil and gas consultant and former general manager of business development at Indian Oil Corporation. “With just 20 per cent of the demand left, refineries have been planning to shut down operations”.
What added to the challenge was tensions between the world’s biggest oil producers and their reluctance to commit to a wider oil output cut. Back in February, Chinese refiners already started slashing output by at least 1.5 million barrels a day due to a countrywide factory production halt. Despite the early indicators, the Organisation of the Petroleum Exporting Countries (OPEC) and a coalition led by Russia were unable to reach a consensus to curb oil production until mid-April when OPEC members and OPEC+ ministers finally pulled off a historic deal to cut 9.7 million barrels a day, about one-tenth of the world’s oil supply.
While the oil slump might not have dealt crude producers a major blow, the key implications lie in the financial outlook of the petroleum industry. “It starts to hurt cash flow quickly and therefore, everyone is rushing to cut capital expenditures and operating expenses to preserve liquidity. It is also starting to hurt valuations of the resources used as collateral for loans,” said Scott Munro, independent consultant at Bheinn Advisory.
Potential Ways Out For The Oil Glut
Slumping demand and swelling stockpiles also mean oil storage tanks are filling up fast. As a result, oil companies either have to get creative with the ways they handle the unwanted crude or pay buyers, if any, to take the obligations off their hands.
“It’s a cliche but the best solution to a low oil price is a low oil price. It will take some time but the only way to resolve excess crude is for supply and demand to get back into balance,” said Munro.
“Most onshore and floating capacity of oil storage has been filled up, and the only way out to this situation for most crude producers is to reduce their production by almost 30 per cent in the near term as creating more oil storage capacity is very unlikely,” Andleigh added.
Bailouts Await
Some of the biggest losers from WTI May contract’s price slump are financial institutions, airlines and petrochemical companies that engage in the hedging practice, and they were left squeezed between crude producers and buyers when the prices collapsed.
“The big question that needs to be answered is how much oil will the world need for 2020, and where will the demand come from?” Munro added. “Low cost producers will always be the first in the queue to supply, so the likely outcome is reduction in demand driven by COVID-19, and subsequent economic contraction while higher cost producers get squeezed out of the market”.
As the oil and gas industry continues to grapple with COVID-19 impact, Munro said there will be an industry-wide reduction in expenditures. As loans mature or need to be rolled over, a significant number of bankruptcies can also be expected. “This doesn’t necessarily remove the supply since Chapter 11 is likely, and banks that have exposure are rumoured to be preparing to take over assets and insert teams to keep the businesses operational. Separately, the lack of demand is squeezing storage and transport capacity so we could actually see production curtailment simply driven by an inability to find anywhere to put the oil”.
Oil’s New Normal
When asked if there are any opportunities brought by the recent oil crash, Munro sounded an optimistic note: “This type of event is likely to separate out the efficient from the inefficient supply and hopefully, the industry as a whole will recover as a more efficient business. Large systemic changes are also likely to accelerate the adoption of new technology, remote work and automated systems particularly as companies prepare to be more resilient in the event of future pandemics”.
Andleigh said the June contracts remain key to watch. “Similar situation could happen as few may be able to take physical deliveries, and the prices might go negative again. The average crude prices these days are slightly higher than US$20 a barrel, and it is likely to remain like this in the near term”.
When the virus outbreak subsides, Andleigh does not see a sudden rebound to pre-COVID19 levels in terms of demands for jet fuel and petroleum products but a gradual process that will take at least two years. When the time comes, the global aviation industry will also have to figure out how much reduction in the passenger load as well as cargo load the industry will have to carry out to comply with virus precautions that will remain in place.