On the 20th of April of 2020, at around 2pm, something historic happened: WTI, short for West Texas Intermediate, crude oil futures traded at negative prices for the first time ever. From there, everything went downhill, and oil prices reached the impressive mark of negative $37.63 a barrel, which translates to a 300% crash. For perspective, this means that if you had bought the oil contract which traded at that price, you would have been paid $37,630, as the contract entailed the sale of a thousand barrels of crude. However, as expert Neil Irwin pointed out, “that is about five tanker trucks’ worth, so any joke about storing the oil in your basement will have to remain just that”.
The immediate reaction by many economics commentators to this bizarre event was to simply shrug it off as price adjustments to the collapsed demand for oil. Some also blamed it on lack of storage at the Cushing, Oklahoma delivery point. While this certainly isn’t false, it is a very simplistic way of looking at a complex market with many strong players. American and Saudi elites, in particular, have very significant stakes in oil production and market manipulation has become, over the years, a normal practice. In fact, meddling by powerful oil players is probably why most media outlets have not been very helpful in their reporting of the oil price crash. So, let’s take a serious look at what’s been happening in the oil market for the past few months, shall we?
West Texas Intermediate is one of the three most used benchmarks in oil pricing. Together with Brent crude and Dubai crude, it provides a reference price for buyers and sellers. WTI is also called Texas light sweet, because of its low density and low sulphur content. In fact, of the three benchmarks it is the least dense and contains the least sulphur. On the New York Mercantile Exchange, WTI is used as the underlying asset of most oil futures contracts, which gives it a very prominent position in the US domestic market. Its price settlement point – what most of us would call delivery point – is the now famous city of Cushing, Oklahoma. This small settlement of just under 8,000 inhabitants is home to the Cushing Oil Field, which dominated U.S. oil production during the first half of the twentieth century. Because of this, huge storage facilities and multiple in- and outbound pipelines were built there, to the point of the city being known as the “pipeline crossroads of the world”. As the Oil Field’s importance waned, the New York Mercantile Exchange took the opportunity to use the existing infrastructure as WTI’s delivery point, instead of building huge facilities from the ground up, which would have been a major and potentially risky investment.
Since the beginning of March, oil prices around the world have been under significant pressure, not from the current health situation, but from a price war between Russia and Saudi Arabia. As demand started contracting in the early stages of the outbreak in the West, the Saudi elites sought to artificially inflate oil prices through a reduction in worldwide output. To achieve this goal, Saudi Arabia tried to coordinate with fellow member states of the Organization of Petroleum Exporting Countries, also known as OPEC, and Russia. Now, Russia doesn’t belong to this organization, but they have been cooperating since September 2016, in an informal alliance dubbed “OPEC+”. However, when Saudi Arabia tried to push further production cuts in reaction to the pandemic, Russia walked out of the agreement. The Russians’ objective was to create a price war as retaliation for the Trump Administration’s newly imposed February 2020 sanctions. Much to their joy, the Saudi’s drew on their huge reserves and started pushing down oil prices. As a result, over the course of a few week, oil prices dropped significantly, with Brent oil crashing by 24% and U.S. oil falling by a whopping 34%. The stage was set for major instability in the oil market.
It was then that Western governments started issuing stay-at-home orders and imposed lockdowns, all but obliterating 40 to 50 percent of oil demand. As you know, it is a basic economic principle that prices are set by the equilibrium between supply and demand. Hence, if demand suddenly crashes, prices will crash too. Eventually, supply will adjust to the new conditions and a more favorable equilibrium price can be reached. Depending on the market, this adjustment can be almost instantaneous, or it can take a long time. Unfortunately, the conditions faced by oil producers mean that they can’t react quickly. Some people have suggested that, given the problem is severe oversupply, oil production should be simply shutdown, thus all but making oil a very limited commodity. While at first this might make perfect sense, two major problems arise. The first is that such action would require coordinated action by all oil producers worldwide, which Russia and Saudi Arabia showed is very difficult to attain. The second is that production facilities can’t be switched on and off at whim, as it can severely damage their infrastructure and, in some cases, even compromise the oil field. The problem is that, even if all oil producers reduced their activity to the bare minimum required to avoid infrastructure and field damage, supply would still be pointedly oversized in comparison to demand. Therefore, prices face a huge downward pressure. Add to this the effects of the price war between the Saudis and Russians, and you can see the perfect storm forming in the horizon.
In come the speculators and their financial shenanigans. Now, you might be surprised to know that a very significant portion of oil futures contracts are held by traders with no relation to oil companies or refineries. That’s because futures are a type of derivative which works by setting a fixed date and price for the sale of some asset in the future. This allows speculators to buy futures far before their settling date and then sell them later, at a profit, to refineries that will actually take delivery of the oil. So, at any one time, a speculator may own the rights to thousands of barrels of oil without ever seeing them, which gives rise to a disconnect between financial markets and reality. In effect, anyone can own significant amounts of oil without even having a clue of how it can be put to any use in real life. Usually, this is not a problem: in the months before the futures’ settlement date, speculators do their speculating and as that date approaches, they simply sell off the contract to someone who knows what to do with the oil. However, with people staying at home, there is little demand for fuel, so refineries cut back on their production and, as a consequence, they don’t buy any more oil. So, on the 20th of April, speculators found themselves holding futures which would be settled on the 21st and which no one wanted to buy. If they couldn’t get rid of them, they would have to take delivery of the oil and, as I’ve already said, you can’t exactly keep a thousand barrels of oil in your basement. An alternative would be booking some storage space at Cushing, but it is almost always fully booked by oil companies and refineries. Thus, speculators had to sell at whatever price they were offered. As prices were already low and investors expected them to drop even further, speculators had no option but to start selling at negative prices. In effect, they were paying other people to get the futures contracts out of their trading accounts.
Watching all of this, Saudi Arabia realized the long-term gains it could realize. Instead of having to compete with U. S. shale oil companies and constantly drop production to inflate prices, they could raze the U. S. oil industry to the ground. This would return OPEC its hegemony over the oil market and effectively allow it to restore prices to 2014 levels, when the barrel of oil easily traded at 80 or 90 dollars. So the Saudis did just that – they flooded the market with fresh, cheap oil. They put together a fleet of 24 VLCC supertankers, topped them up with 50.4 million barrels of oil and sent them the United States’ way. At the time of recording, most are still on their way, but some are already in U. S. waters. According to Senator Ted Cruz, this inflow of oil is more than seven times the typical monthly flow. Like other American politicians, Ted Cruz wants to prevent the devastating impact this would have on the economy, writing “My message to the Saudis: TURN THE TANKERS THE HELL AROUND.”. In fact, President Donald Trump has announced that he is looking into banning Saudi oil imports. This would prevent the Arabian kingdom from flooding the U. S. market and secure American oil companies against foreign competition, at a time when competition might actually do more harm than good. However, it won’t stop the Saudis from pushing oil prices down by selling directly to other countries. Besides, there is talk that the Saudis might start accepting payments in currencies other than the dollar, which would set the precedent for other OPEC member states to do the same. This would be the downfall of the petrodollar system, which is the source of a significant portion of the U. S. dollar’s relevance in international trade. This would be a strong blow to the American economy, given that a diminishing demand to the dollar would probably induce its devaluation and introduce further volatility in its exchange rate. Coming at a time when the Fed is planning one of the biggest quantitative easing operations ever, it could result in rampant inflation. It would also play in China’s favor, as its government has been driving an effort to replace the dollar with Chinese currency in international transactions. If America wants to stop this, a simple ban on Saudi oil imports won’t do.
Some American politicians are already proposing more decisive action against Saudi Arabia, including recalling U. S. troops stationed in the Kingdom. What do you think should be done?