Earlier this week came the news that oil prices had fallen into negative pricing. But what does this mean for the wider economy? And will the prices recover? Charlie Buxton, our Portfolio Manager in Hong Kong, explores the situation.
It’s a rare occurrence when someone pays you to take something away; it’s safe to say we never see it on the high street although it occasionally happens in business – usually in very limited circumstances.
Yet this week the price of oil fell so far that it reached negative territory; another unprecedented event. A combination of factors, including producer price wars, a global collapse in demand, a glut of supply, limited storage options and the usual flow of the futures markets all played their part.
Although unheralded, the fact that oil sellers are paying buyers to take their oil comes down to a simple reason. It may be cheaper for them in the long run. Ultimately closing production, which may damage wells, or struggling to store crude oil could be costly. The technicalities of the oil market – in that price is determined through futures contracts – also impacts things, by creating a false element of demand which at present clearly isn’t there.
A flood of oil
Energy markets have been turned on their heads by the pandemic, with the demand in oil falling significantly as lockdowns were extended country by country. Added to this came an issue between Russia and Saudi Arabia, the world’s biggest oil producers, which resulted in the collapse of a pact to limit production. Both countries increased supply and huge volumes of crude oil became available, quickly. A rapid deal between OPEC, Russia, the US and 20 other countries agreed a production cut of 10%, but this was deemed ‘too little, too late’ and prices started to fall, initially in the US and then globally.
The effect of the futures market
Oil is traded according to its future price; the market operates with buyers locking in a purchase for a specific price at a specific time, enabling users to hedge against price swings. These contracts are for a set period, and those associated with May deliveries were set to expire on 21 April, creating something of a ‘perfect storm’ when it became clear the demand just wasn’t there. Selling at a steep negative price offered a better option, exacerbating the market falls.
Running out of storage
With demand falling, and supplies increasing, the inevitable outcome was that storage would be at a premium. The main storage facility in the US has seen stockpiles increase by 48% to 55 million barrels; its capacity is 76 million barrels. Other options are now being considered including storing crude oil on ships and rail tankers. The US is also reviewing a plan to pay producers to keep oil in the ground on a temporary basis, which could see the country enjoy healthy profits whilst protecting the sector.
The impact on consumers
Ultimately we should start to see the effect of this global situation at the petrol pumps, and possibly, in our energy bills too. It won’t be immediate, and it’s important to remember too that taxes make up a significant part of petrol prices, but given that oil prices have fallen this far there will be a positive impact for all of us as consumers. The old adage that ‘it rises like a rocket, drops like a feather’ is important to remember when it comes to translating market falls to our own pockets.
Demand will only begin to build as lockdowns ease and recovery begins. The oil sector, as with many other facets of normal life, is at the mercy of the Coronavirus pandemic. As normality returns, prices will increase, and it’s unlikely that there will be a fundamental impact on the sector over the medium to long term.
Significant market events, such as the unprecedented fall in oil prices, can be concerning. We are here to help when you are making any investment decisions. To discuss any aspect of your portfolio please contact your nearest office.
Charlie Buxton, Chartered FCSI, Portfolio Manager