Problems in store: what’s going on with oil prices?

Schroders
Simon Stevenson
Simon Stevenson
Schroders Deputy Head of Multi-Asset
0
As the price of oil turns negative for the first time ever, we examine what the wider implications for the economy and the energy sector could be.

As countries around the world went into lockdown to curb the spread of the deadly Covid-19 virus, demand for oil collapsed. And on Monday something quite extraordinary happened; the price of West Texas Intermediate (WTI), the grade of crude oil used as a benchmark, turned negative for the first time ever.

This means that oil producers are paying buyers to take the commodity off their hands due to fears that storage capacity could run out.

Although weaker demand and an uncertain short-term outlook played a part, much of the reason for this sharp fall in the price can be explained by a technicality of the global oil market and a lack of storage capacity. Oil futures contracts relate to specific delivery periods, and the current WTI contract for deliveries of crude oil in May was due to expire on 21 April.

Unlike Brent (one of the other main benchmarks for oil prices), WTI contracts are settled by physical delivery, with the owner of the contract on the day of expiry getting the barrels of oil. With many oil traders in the financial markets unable to take physical delivery, there was a rush to offload these holdings to avoid having to incur storage costs.

Earlier this month, the Organisation of the Petroleum Exporting Countries (OPEC) and its allies agreed a deal to cut global oil output by around 10%. This was the largest reduction in oil production ever agreed and followed a price war between Russia and Saudi Arabia. However, many analysts said that the cuts weren’t big enough to cope with the fall in demand.

US president Donald Trump has dismissed the price fall as a short-term problem and has pledged to buy up some of the oil for the country’s national reserves. However, with storage capacity at the WTI hub in Cushing, Oklahoma (the main delivery point in the US for oil) set to run out in the middle of May, concerns are growing that this may prove to be a more long-term problem.

To assess the impact of negative oil prices on the wider economy, we spoke to Keith Wade, Schroders’ Chief Economist & Strategist, and Mark Lacey, Schroders’ Head of Commodities.

Keith Wade, Chief Economist & Strategist:

“Under normal circumstances, lower oil prices help households by pushing down inflation and boosting spending power. At the moment though that’s not happening as people aren’t driving and most retailers are shut for the lockdown. So there is little opportunity to receive the benefit and spend more elsewhere.

“Once the lockdown is lifted there would be an opportunity to spend, but demand for oil and fuel prices will also rise at that time so it’s hard to quantify. On balance I would see this effect as a minor positive for most oil consumers.

“However, there is a significant negative as oil producers have to cut back on production to match demand and financing costs have risen steeply for the sector. Shale gas producers are already cutting their capital investment and this will drag on activity and deepen the recession in the US before any consumer benefits come through.”

Mark Lacey, Head of Commodities:

“The biggest impact will be bankruptcies. Despite many oil companies cutting capital expenditure by up to 50%, many, many companies are going to go bankrupt. Around 80 oil and gas companies filed for bankruptcy in the 2015 sell-off. The current situation is far worse than 2015, so the industry is going to look very different after this wash out. These bankruptcies will not be limited to the US, but will also likely occur in Asia, Latin America and Europe.

“At current prices, many oil companies around the world are starting to “shut-in” production. This is when they put a cap on production that’s lower than the potential available output.  

“At the start of March the shut-ins were gradual but they are now accelerating and a lot of these will be permanent, with many fields potentially not restarting even if prices recover back to $60-$65 per barrel. Industry research suggests that as much as four million to seven million barrels a day could be permanently lost as a result of these shut-ins.

“Monday’s price action was the result of physical traders that had committed to taking delivery in Oklahoma not being able to store the crude, to the point that they had to pay storage holders one-off payments of between $40 per barrel and $50 per barrel to hold the crude for a few days.

“I would expect the June and possibly July WTI contract to remain extremely volatile over the next few weeks as full storage in Oklahoma is unavoidable. However, it’s important to point out that this is not specific to the US market. Around the world, storage terminals will fill up and this will force even bigger cuts from OPEC and non-OPEC producers.

“The shock to the global oil market as result of Covid-19 restrictions is unprecedented. The oil market has never experienced a fall in demand of this magnitude. From what we are already seeing, this will have a long-term impact on the supply dynamics of the oil industry for many years to come. And despite recent cuts to production, the most important driver for any recovery will be demand.”


This is an article originally written by the Schroders Investment Communications team.

Important Information:
This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.

Learn more
Established in 1961, Schroders in Australia is a wholly owned subsidiary of UK-listed Schroders plc. Based in Sydney, the business manages assets for institutional and wholesale clients across Australian equities, fixed income and multi-asset and global equities.

Schroders believes in the potential to gain a competitive advantage from in-house global research; that rigorous research will translate into superior investment performance. We believe that internal analysis of investment securities and markets is paramount when identifying attractive investment opportunities. Proprietary research provides a key foundation of our investment process and our world-wide network of analysts is one of the most comprehensive research resources dedicated to funds management.

Areas of expertise:
Australia equities
Fixed income
Multi-asset
Global equities

Why Schroders?

With a global network of researchers, we focus on serving our clients and targeting one result - superior investment performance.

Inherent in our approach to investment management is:
A structured, disciplined and repeatable investment process
A clearly defined investment style
A team approach to investment management

A global asset manager

We have responsibility for A$803.1 billion of assets* on behalf of institutional and retail investors, from around the world. Their assets are invested across equities, fixed income and alternatives.

We employ over 4700 people worldwide who operate from 41 offices in 30 different countries across Europe, the Americas, Asia and the Middle East.

We are close to the markets in which we invest and our clients.

Schroders has developed under stable ownership for over 200 years. Long-term thinking governs our approach to investing, building client relationships and growing our business.

*Source: All data as at 30 June 2018