Oil prices recently dropped to below zero. You might ask how that is possible?

What happened?

First, it is important to understand there are dozens of oil prices. Different production locations receive different prices. Different qualities of the oil itself, depending on where it is produced, receive different prices.  And importantly, on April 20, the “oil price” that business news channels and newspapers referenced was that of a barrel tied to a futures contract, a contract to sell oil at a future date.

Price differences exist between “paper markets” (as part of a futures contract), and “physical markets,” where the commodity is actually handled. The negative price occurred because of action in U.S. paper markets. We know this because overseas futures contracts were down sharply on April 20 but closed at over $25 per barrel, as did contracts that expire later in 2020 and beyond. Physical market prices dropped but not to the same degree as futures. 

In short, futures contracts expire and the May contract for West Texas Intermediate (WTI) (a benchmark used in oil pricing) expired on April 21. If an owner holds the contract to expiration, the contract is fulfilled with physical oil. As the world runs out of places to store unwanted crude (which we will discuss below), no one wanted physical delivery, and selling begat selling begat selling.

Another market structure quirk is that oil exchange traded funds (ETFs) do not own physical barrels.  One futures contract is for 1,000 barrels. That’s a lot to store! This is unlike gold ETFs that do own gold bars. The ETFs own futures and, upon expiration, must sell the current month and buy the next month.  Here too, there was a lot of selling and no buying.

Market structure and mechanics have not changed, but they are different today which has caused the negative price outcome because the physical supply and demand is wildly out of balance.   

Why the oil glut?

Automobile and airline travel has slowed to a crawl. The Transportation Security Agency (TSA) data notes that commercial airline passenger counts have dropped by about 95%. During the 2008-2009 Great Recession, oil demand dropped by about 5% over the course of 15 months. This time demand is forecast to drop by about 25% to 30% in a matter of weeks. 

The supply/demand mismatch was exacerbated in March after a failed OPEC meeting when Saudi Arabia hiked production as part of a price war with Russia. But as the oil glut mounted, Saudi Arabia and OPEC, along with several other oil producing nations, reversed course and agreed to cut production by about 9.7 million barrels a day beginning in May. But that was nowhere near sufficient to compensate for the steep drop in global demand.

Even with promised cuts, storage space is nearing full capacity. Onshore storage capacity is essentially fixed. Traders can store oil in offshore tankers, but rental rates for supertankers have increased by more than 10-fold in less than two months.

It is entirely possible a similar scenario will unfold in 30 days when the June WTI contract approaches expiration.

What’s ahead?

There is a saying in the oil industry that “the cure for low prices is low prices.” Behavior in the domestic oil industry is changing dramatically as capital budgets are slashed, employment is reduced, and a focus on servicing, if not cutting debt, becomes a priority.

We expect that capital will not flow to the industry, new wells will not be drilled, and old wells will be shut down. Furthermore, wells shut down today might not return tomorrow, as sub-surface damage is possible after prolonged disuse. This industry response will probably persist until oil prices approach $40 - $50 per barrel. In short, the economics of supply and demand, combined with the financial demands of credit and capital allocation, will make this change in behavior a necessity.

So far, the U.S., which is the world’s leading oil producer, has not committed to making substantial cuts in production, in part because production comes from private companies unlike with most OPEC nations where governments control the output. Still, U.S. producers may have no choice but to cut production.

In fact, at current physical market prices, most U.S. producers can no longer produce oil profitably. We believe that hundreds of U.S. oil producers could file for bankruptcy this year and in 2021 if oil stays at this price level.

While travel will eventually pick up as the effects of the pandemic subside, it is expected to be many months before travel returns to previous levels and inventories are drawn down. But the industry is cyclical and there will be an upcycle at some point.

Many companies that had funded themselves in the high yield bond market had hedged their price risk at about $50, so they have bought some time. However, there are significant debt maturities that will have to be refinanced this year and through 2022. It is possible after this severe downcycle concludes, surviving companies will be far more financially disciplined and attractive to generalist investors. 

With energy stock and bond prices at such distressed levels, some opportunities are emerging – but it’s still early. Energy bonds of some surviving companies will provide equity-like returns for long-term investors. We are focusing on companies with no refinancing needs until 2025 and that have superior acreage positions which can be developed profitably at low breakeven oil prices. The bonds of some of these possible survivors are trading at 50 to 60 cents on the dollar.

In the equity market, we are targeting quality companies that are well-positioned with superior returns on invested capital, line-of-sight to improved returns, with trusted management teams. For a commodity-reliant industry where the low-cost provider has the long-term advantage, these characteristics are particularly important. Commodity price risk is inherent for energy companies. We are favorable toward companies that do not layer financial leverage on top of commodity leverage. We have taken advantage of severe price movements among energy equities to further increase allocations to the highest quality companies.