Oil prices are collapsing, but the bad news is that you’re going to get very little direct benefit from it anytime soon.
With a massive global oversupply of oil, due to a collapse in demand brought about by national lockdowns everywhere, traders are paying to get out of futures contracts, and this has led to a collapse in the price of US oil.
On Monday, the price of a barrel of West Texas Intermediate (WTI) went negative, showing the massive dislocations in the global economy being caused by the Covid-19 pandemic. WTI fell briefly to -$40.32 because traders were desperately trying to get rid of oil they had agreed to buy for delivery in May. They had to decide whether they would take delivery of the oil, or pay others to take that risk.
It seems crazy, but for oil producers, keeping on pumping for a while at least and paying to have oil taken off their hands is cheaper in the short term than shutting production and damaging their oil wells.
Traders, who have no intention of accepting the physical oil, swap contracts among themselves, betting on the future direction of the market. But they too have been caught out by the sudden price drop.
It has never happened to this extent before.
WTI is important as it is used as a benchmark for oil prices in the US. It is a particularly high-grade oil, the sort JR Ewing would have produced in the 1970s soap opera Dallas. It’s billed as “light sweet crude”, which means it has a low density and a lower sulphur content than many others, which makes it easier and cheaper to refine.
In SA, you will see oil prices quoted on your favourite news website as “Brent crude” which is regarded nowadays as a better indicator of global oil prices, as it draws from more than a dozen fields in the North Sea. There are also more storage facilities for Brent crude, which is why traders are not panic selling. But the collapse in WTI, while indicative of a global oil glut and a warning that the US industry is in serious trouble, does not mean a total collapse in the price you pay for fuel.
When futures contracts expire, traders usually just roll their positions over into another contract for a later month. Usually traders would simply have sold the May contracts they held, and bought the June contract – and there would have been little difference in the price. Monday’s collapse, however, meant that the spread between the price in May and June widened to its highest level ever, and with a risk of an oil glut, buyers demanded to be paid.
Usually, the market works very well, ensuring a balance between supply and demand. When a bit too much oil is produced, prices come down; when too little is produced, it goes up.
Everyone understands how prices are normally determined in the futures market: you agree to pay a price today for delivery in a few months’ time. There is also a market for speculators – people who have no intention of ever taking delivery of the oil but make a margin by trading contracts between themselves. But when there’s a sudden drop in demand, the value of contracts collapses as traders frantically offload those to anyone who will buy them.
Consider how this happened in the oil market. A year ago, the world was consuming about 100-million barrels of oil a day. But the lockdowns imposed by governments around the world seeking to avert the collapse of health systems have meant demand has fallen by about 30% though production levels have not been significantly cut. This has led to a massive surplus and few buyers, since people are running out of space to store all that oil.
Most US oil storage facilities are full and a growing number of producers are now hiring tankers, which you’d normally use to shift the stuff across the world, to store it until demand returns. That comes at a massive cost. A record 160-million barrels are currently being stored on tankers as refiners process much less oil than normal into fuel. Despite significant cuts in production by oil cartel Opec, it’s not yet enough to reduce stockpiles.
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It’s been a great year for drivers and those who deliver goods as Brent oil prices have collapsed around 60% this year. Before this storage crisis, Saudi Arabia and Russia became embroiled in a price war, each pumping more than normal, which pushed prices below what it costs to produce oil. It was a classic standoff: the Russians were hoping the Saudis would cut production, and the Saudis were hoping the Russians would.
In the end, the Opec cartel relationship held sway and they both agreed to cut production by 9.7-million barrels a day. But those cuts, if they happen, only come into effect next month. Ordinarily, you’d then expect oil prices to recover – but the collapse in demand, and storage facilities reaching capacity, led to panic.
For SA consumers, this would ordinarily be great news. The fuel price will drop by more than R2 a litre in May, after a similar reduction in April. But the fact that you are barely driving anywhere means you will get little benefit from the new price.
So just how low can the petrol price go, you wonder. Arguably, as low as about R7.50 per litre, as that is the base cost determined by the government, which charges taxes and a range of levies as well as a fixed fee to refiners and retailers to ensure that more than 100,000 pump attendants are paid. Of course, it won’t ever fall that low, as oil markets have a way of righting themselves. As inventories fall and production is cut to meet new lower levels of demand, prices will recover.
Still, the effect on oil-export-dependent African economies like Nigeria and Angola will be devastating, and it will also have a negative impact on the operations of SA companies that have businesses in those countries. The share price of mobile operator MTN, for example, has proved especially vulnerable due to its exposure to oil-dependent economies in Africa and the Middle East.
Usually, a big drop in oil prices would be positive for the world, as it would reduce the cost of transporting goods and people and would add to global GDP. But not this time: there is so little economic activity that there is no actual saving happening, and thus the effect is negligible.
There is one piece of good news, though: the lower oil price does reduce pressure on domestic inflation that comes about due to a weaker rand. SA is an oil importer and with the currency close to record lows set this month, higher oil prices would have worried the Reserve Bank’s monetary policy committee, which remains alert to inflation risks in the economy.
But the drop in oil prices will give the Bank further comfort as it continues cutting interest rates in response to Covid-19.
If there is a benefit, it is this – unless of course you rely on interest income, but that is a whole other story.
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