• Christopher Hall

What made oil prices go negative?


When the U.S. oil contract for May delivery closed at a negative price, -$37.63/barrel, investors asked whether they would be paid for putting petrol in their own cars?

While this question might seem absurd, this effectively happened for a specific circumstance in the US oil markets.

Hugh Dive from Atlas Funds Management explains how this anomaly occurred and what the economics are behind the petrol station that will stop us getting paid to fill up our cars.

[00:00:50] Last week, the US oil contract closed at a negative price installations minus thirty seven point sixty three dollars a barrel or one thousand barrel contract of May delivery is a strange move in. The oil price comes after a few years of negative interest rates in Europe, something unprecedented in human history. Interest rates were first set in Babylon by him at Rabie in 1772, B.C.. We certainly live in strange times that are not easily explained by traditional economic theories. However, in today's Torpedo Tuesday, we're going to look at how we have negative oil price, where producers, where producers are effectively paying customers to take it off the hands. And as usual and torpedo Tuesday, we're joined by Hugh Die from Atlas Funds Management. Good morning, you. How are you? [00:01:40][49.3]

[00:01:40] Good morning, Chris. Great. [00:01:41][0.6]

[00:01:42] This is very interesting times and we've had a lot of strange questions coming from investors, clients and children alike. What's what's some of the top questions you've been getting on this topic or questions about my children? [00:01:54][12.3]

[00:01:55] Whether if I go to a service station, will they pay me money to take away? Tell you this. I mean, that doesn't make any sort of sense that that a producer of a good or something of value would pay a consumer money to take it off their hands. [00:02:11][16.2]

[00:02:11] It doesn't sort of really doesn't make sense at all. It's the economic principles just don't stand up. And what we haven't seen that at Bowzer and filling up now is definitely what's been happening from the producers in that specific May delivery contract. [00:02:26][14.5]

[00:02:27] Yes. So that there's a range of factors, of course, that particular contract in the United States to go negative or to get them to run a true children's question is an absurd question. [00:02:38][10.8]

[00:02:38] It's actually has been happening. But we'll look at because of how and why we got there. So to get there, I guess it's it's a good place to start with when we're looking at oil. Probably one of the first metrics we'd look at is the cost of production. So hence the costs the cost of production vary across the globe. [00:02:56][17.6]

[00:02:57] Well, Shell, the United States costs more than conventional oil to extract and with cost per barrel ranging from about $40 to $90 a barrel, the costs would come down quite dramatically with improvements in hydraulic fracking technology. Globaly, the cost of conventional varies varies. It varies a lot with Saudi Arabia can produce under about $10 a barrel with worldwide costs around about 30 to 40 a barrel. So car prices even excluding some negative a lot. Most producers are actually losing money. I mean, in Australia, Woodside has the lowest cost production around about sort of foreign strategic $5 ballah barrel, which looks pretty good. But this appetitive at this metric ignores that the tens of billions in sunk costs required to build the offshore oil rigs and fields that are 100 kilometers off the coast of Western Australia. [00:03:48][50.9]

[00:03:49] I guess that's a critical point to put in. The footnote now is a few weeks ago we have trains urban and saw that traffic was down on their toll roads somewhere between minus 40 percent, minus 60 per cent depending on which road we're looking at. Is low global demand impact that will markets. [00:04:07][17.8]

[00:04:08] So in April 10 20 trains said that the global demand for crude oil, which is yourselves at petrol and jet fuel, has fallen quite heavily and the United States has seen their storage capacity go up because airlines motorists are using as much oil as they were before the crisis because motorists prevented from driving and airlines from flying. So with storage of capacity, those those for the capacity, the normal ability to store oils like refineries, airlines just simply out buying crew on the world market be more at current. [00:04:43][34.7]

[00:04:44] Currently, the current prices have definitely fallen. Take the global surface. An understatement. What normally happens in this environment when the oil prices fall isn't there's normal market mechanism. [00:05:00][15.6]

[00:05:01] Yeah. I mean, normally during times of weakening global demand, the global oil cartel, which is OPEC or plus which is I think Russia sort of cut production to maintain prices and to stop things too much. [00:05:15][13.3]

[00:05:16] It seems as though it's been a little bit different in 2020, has it? [00:05:19][3.3]

[00:05:20] Yes, very, very different. I think it's a miscalculations on behalf of our brothers, Russia and Saudi Arabia. So remember, early sort of marginal with despite world demand looking rather grim in March, because we saw that this early march, the world's biggest oil importer, China, was actually turning away. Tankers arriving Robert Shores of some of their coasts. The Saudis and Russia decided to enter into a price war on March. [00:05:49][29.0]

[00:05:49] The. [00:05:49][0.0]

[00:05:51] After the Russians refused to reduce production to nawlins, it's no surprise, so in response to this, on March 10th, the Saudis announced that actually increase the daily oil production to 9.7 million barrels to twelve point three. [00:06:05][13.6]

[00:06:05] And then Russia announced they're planning to increase the production by 300 barrels a day. So into a market where demand is weakening and weakening very, very sharply, very different, different to the GFC, we saw the two big producers actually deciding to pump more into the market, which is a very unusual situation. [00:06:24][19.0]

[00:06:25] Counterintuitive. It would seem a normal market. So what happened to the US shale shale oil markets in this movement? [00:06:33][7.5]

[00:06:34] So at the same time, the US shale companies certainly have continue to produce despite low crop prices. And that's an effort they're obviously commercial companies, whereas Russia and Saudi effectively places a government owned organizations. Rosneft and Saudi Aramco. So the shell companies kept on producing in order to generate some cash flow to pay interest due to banks and bondholders. And some something from very different to the GFC is that the US has delayed, production has doubled. Actually, the current approaches of 30 million barrels are the large producers in the world. That's changed. So we'll be going through. The GFC uses still massive oil importer. They've now moved to an oil exporter. So you've had have sort of. Yeah, production. It's more production coming out of Saudi Arabia and Russia and the Americans not changing any of their production at the same time. [00:07:26][52.1]

[00:07:27] Qantas supplies flooding, the market demands. And the headlines are showing us oil prices the same across the globe. [00:07:36][8.7]

[00:07:37] Not not historically sort of global global oil prices haven't fallen as heavily as the US prices. And the reason for this difference is there's a there are two key benchmarks. So when West Texas Intermediate, which is effectively captures the oil price, the United States and Brant, which is cruisy priced in the middle of the north, say the prices are generally different. Currently, historically, the US price has been higher than than the Brant. But however, since the US have moved to an oil sort of exporter, the Brant price has always been a bit high, has now been higher. So Brant is priced in the middle of the NSA. So where there's lots of tanker storage and it's quite accessible, whereas the American price of West Texas is priced way in the United States with storage is limited and it's also landlocked. As a result, sort of the Brant price was more moved from the coronavirus demand shock while the US prices were more sensitive to that shock. [00:08:40][63.1]

[00:08:41] Know isn't the US only importing oil, so couldn't they just supply to the US? [00:08:46][5.0]

[00:08:48] Well, so historically the US has been the world's largest importer. This changed mid last decade. And last year with the rise in US shale oil. And indeed, last year, the US military to an oil exporter. And as a result of the rapid change in the US energy fortunes, all of their existing infrastructure is designed to move import oil from the coast of the United States into the major cities, not export oil out of Central American. And it's sort of central the September Texas, Oklahoma and Arkansas to Europe and Asia so that the pipes and all the infrastructure is all built adult over sort of 50 years ago. And so goes the wrong way. [00:09:27][39.6]

[00:09:28] And so that's part of the issue, the infrastructure bottlenecks or constraints in the way of one way traffic now having to go the other way. Now, before we get to the price going negative. Can you explain how the oil price relates to the history of moving oil around the world? Or maybe the US is a sort of case study. [00:09:48][20.7]

[00:09:50] So the NYNEX crude oil fortune futures at a primary price for US oil. So this futures contract towards the price of a thousand barrels of oil to be delivered into the massive oil logistics hub in Cushing, Oklahoma, over the course of any particular month so that the contracts are sold by all producers. So shale gas producers to lock in prices for future productions, since they can sort of slow their their earnings. And they're ultimately the contracts are bought by refiners or storage entities to lock in prices for purchase. These contracts are also bought and sold by all traders to mediate prices to buyers and sellers and also to make some sort of profit in that. So say traders, hedge funds more recently said oil ETF buying those sort of contracts, but ultimately looking to sell to an end user. [00:10:39][49.7]

[00:10:40] So the real uses the refineries and the producers and the speculators, the hedge funds, the trial traders buying and selling an ETF. And what happens when that contract expires? [00:10:51][10.6]

[00:10:53] So when you hold contract to expiration, it's very different for a physical commodity as opposed to a stock. You have an obligation to to make that the delivery to the buyer. So normally winter contracts expire, traders will sell contracts to demand sources such as airlines or refineries that can take delivery. And they they've also got storage. And this has minimal impact on prices. However, storage facilities are finite. With Cushing, the central hub, there are no climber's storage, but 76 million barrels. And that's now close to full. And so there's limited. And there's also because of the change in the U.S. energy fortunes over the last sort of five to 10 years, there's a limited means for that oil to flow out from Oklahoma onto the onto the war or markets. So there's a localized problem goes into the price. [00:11:43][50.5]

[00:11:44] And that does that get us to the negative prices? Neal? [00:11:47][3.5]

[00:11:48] Well, the problem is with a lot of the speculators buying those buying these oil 9x futures, the hedge funds that have only those oil contracts are looking to profit from a rise in the oil price. And they were faced with a situation where three things happened. They couldn't find a buyer for the contract on exploration. But the hedge fund based in southern New York or Houston doesn't physically want to take delivery of thousands of barrels of oil off of there. And they had no trouble actually finding a place to store the oil. So in that situation, yes, sort of very difficult times. [00:12:25][37.0]

[00:12:27] So that's situating the hedge fund owner. Owns oil contracts and is forced to pay buyers to take delivery of the contract. Is that exactly? [00:12:40][12.9]

[00:12:40] Yeah. Because I got no place to store it. They don't want to at least physically take delivery. So, look, you know, barrels of oil delivered to the state meeting in Sydney is just correct. I'm impressed. Many, many years ago, there was famously a grain contract was delivered to a fund in an industry strict because I'd forgotten about that. So if this is local laws lawsuit, though, a contract that says so in a situation like this, hedge funds will pay people to take to take this oil contract off their hands. And that's resulted in a sort of a negative oil price. [00:13:16][35.9]

[00:13:18] So they start holding the position when they don't want to have it and they've got to get rid of it because they can't do it anyway. So that's the anomaly. If the negative price for the current is negative. Yes. Yes. But for the future, month after the immediate expiration, it was a very different price. [00:13:35][17.1]

[00:13:35] Yes. So sort of looking at the June and July price today, there they are in positive territory. Twenty. But just this particular May contract was looking very grim. Was that resulted in the negative price? [00:13:47][12.0]

[00:13:49] Now, through all this, you have cars and up and the negative prices and life children asking, well, can we get paid to put fuel in your car? What does this mean for petrol prices in Australia? Are they going to fall further? [00:14:01][12.2]

[00:14:02] I mean, they're forno a bit, but notice that the negative $37 for a barrel of oil that barrel is don't forget, liters of petrol is very much a localized event in Central USA and doesn't represent the global price or even a landed price in Australia. So it's coming currently. But I think we talked about this last week with Caltex. Around 40 per cent of the price of petrol are actually taxes that are applied regardless of the world price. So excises 50 to 42 cents a liter and that's regardless the oil price plus 10 per cent GST and 15 cents on top of that is just a riot refining and distribution costs. So where oil prices are sort of petrol about eighty nine cents a liter, that that represents a very low oil price. But there's sort of a there's a floor below, which is any that can fall just simply through taxes and so costs of production. So it's tough to say going any further further. [00:15:01][59.4]

[00:15:03] All right. So this may be as good as it gets for Australians with the lower petrol prices. [00:15:06][3.9]

[00:15:08] We much more. Yeah. Given that sort of run out system, if you're if you're selling, you're buying oil. If you buy a little petulant 89 cents think I saw a couple days ago, sort of 50 sort of Sarah to the 60 odd sensitizes or is his taxes and costs already. So you're effectively buying very, very cheap oil, but it can't go much lower than where it is. [00:15:32][24.2]

[00:15:33] Well, thank you very much for those insights. She died from Atlas Funds Management. Thanks, Chris. [00:15:39][6.2]

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