A Black Swan In Oil

Oil takes an unexpected—and unprecedented—turn.

“Unprecedented” is a word that only begins to describe what’s transpired in the oil markets this year. Not only were long-standing records for oil broken in 2020, they were absolutely shattered, just like prices for the energy commodity.

Perhaps no other asset has been as affected by the economic devastation caused by the coronavirus as oil—not stocks, not bonds, not currencies.

Sure, all those other asset classes have felt the pain of the once-in-a-lifetime sudden stop in the economy. But they’ve been backstopped by seemingly infinite firepower from fiscal and monetary authorities, and have been able—to some extent—to look past the economic valley created by the virus.

Not so for oil. Because of physical constraints, oil prices have been at the mercy of the immediate economic realities in the real world. That’s stymied oil traders—many of which use ETFs—from capitalizing on the commodity’s decline. In some cases, unsuspecting traders have been completely wiped out by what’s essentially the blackest of black swans in the oil market.

The Beginning
While stocks rallied for a good month and a half before topping out, oil prices peaked right at the start of 2020. West Texas Intermediate (WTI) crude oil, the most popular U.S. benchmark for oil, hit $63.27 on Jan. 6.

Shortly after that, things turned sour. Reports of a novel coronavirus in China began to circulate early in January; by the end of the month, the country was in lockdown. Despite this, other countries were hopeful that the virus could be contained to the world’s most populous country, and U.S. stocks hit record highs in February.

The oil market didn’t have the luxury of ignoring the virus. The world’s second-largest economy, China, was also the world’s second-largest consumer of oil. In its February Oil Market Report, the International Energy Agency (IEA) estimated that oil demand would fall by 435,000 barrels per day year over year in the first quarter, largely due to the lockdown in China. Oil prices fell to $51.56 by the end of January, and $44.76 by the end of February.

Spot Oil vs S&P 500

Alliance Breaks Down
By late February, the severity of the coronavirus crisis was becoming increasingly clear. Even U.S. stocks, which were oblivious to the growing number of virus cases around the world, began to crash later in the month.

By early March, it was apparent that the virus had spread well beyond China’s borders. Lockdowns in Italy, Spain and France were followed by shelter-in-place orders in California and New York later in the month.

On March 6, a Friday, oil prices settled the week at $41.28, down 10% on the session, and the lowest closing level since 2016. Talks between the Organization of Petroleum Exporting Countries (OPEC) and Russia had broken down, ending with no agreement to cut production. Saudi Arabia had hoped to convince its allies to trim production by 1.5 million barrels per day on top of existing curbs, but Russia balked at the idea.

The alliance known as OPEC+, which consisted of OPEC, Russia and a number of smaller producers, had already trimmed output by 2.1 million barrels per day over the last several months, with little to show for it. Russia figured there was no point throwing good oil after bad.
Saudi Arabia was furious. The country threatened that if Russia didn’t join in the new cuts, the whole OPEC+ alliance would effectively be dissolved, and countries would be free to produce as much oil as they wished.

With no sign of a deal, the Kingdom followed through on its threat that weekend, dramatically cutting prices for its crude. The country would boost its oil exports to a record high, flooding the market with oil just as demand was collapsing.

Demand Collapse
That following Monday, March 9, oil prices plunged to $31.13, a loss of 24.6%, and at the time, the second-largest daily decline ever.
But while the supply surge was forefront on traders’ minds, little did they know the extent of the demand collapse that was coming. As the coronavirus spread, governments around the world began shutting their economies one by one. Borders were shut, travel ceased and people hunkered down at home.

An onslaught of negative headlines piled up day after day. By the third week of March, it became apparent just how far oil demand would fall. In its latest Oil Market Report, the IEA threw its previous estimates out the window. Demand would collapse by 29 million barrels per day in April, falling to levels last seen in 1995, the agency said. For the year as a whole, demand would be down by 9.3 million barrels per day year over year.

On March 18, oil prices fell 24.4% to $20.37, the first time at that level since 2002.

‘Full Storage’ Fears
By late March, it was becoming apparent that no amount of artificial supply cuts from OPEC or Russia was going to offset a nearly 30% drop in global oil demand. The market would have to hold all of the excess supplies in storage until demand recovered enough to close the gap.

The only problem? Storage tanks were filling up so fast that space to put fresh oil was becoming scarce. The industry was not set up for such an enormous decline in demand.

As the devastation within the energy industry spread, anxiety began to grow. Even President Trump, concerned about the impact low prices were having on the U.S. shale industry, was rooting for higher prices. Out of nowhere, the president claimed to have gotten OPEC+ to slash output by millions of barrels per day. Days later, the deal was miraculously clinched when Saudi Arabia, Russia and their allies announced a massive 9.7 million barrel per day output cut, the largest ever.

But oil prices hardly flinched. The day after the cut was announced, WTI sagged 1.5% and then plunged 10.3% the next day. After a brief countertrend rally, prices were back to $20.

Prices continued to drift lower throughout that week. That Friday, they closed at $18.27, two days ahead of the expiration of the May WTI futures contract. No one could have imagined it then, but the oil market was about to be turned on its head on Monday.

Twilight Zone
April 20, 2020 is a day that will forever go down in history as the day oil prices entered the twilight zone. From $18.27 the previous Friday, WTI collapsed by 306% to settle at -$37.63 by the end of day Monday. That’s right—negative 37.63.

How that happened is still being debated today, but one thing that’s certain is that the oil market had entered that day in an extremely fragile state. Storage levels were rising fast and there was no telling whether there would be any space left to store excess crude in the coming weeks.

With few able to secure storage space, the front-month futures contract for May delivery turned into a hot potato. Some traders, who even ordinarily wouldn’t take delivery of physical oil, were eager to get out of their positions, but had limited buyers to take the contracts off their hands.

U.S. oil-tracking funds like the United States Oil Fund LP (USO) had already rolled their positions into subsequent June contracts well ahead of the May contract’s expiration, but other financial players remained. They had to get out—at any price—and that desperation may be what fueled oil’s descent below zero.

The Aftermath
Oil’s foray into negative territory was brief. The next day, the May contract expired at $10.01. The June contract—which is the front month as of this writing—never got below that level, and has since rebounded to $24.03, suggesting that “full storage” isn’t yet a reality.
In addition to the nearly 10 million barrels per day worth of OPEC+ cuts that have gone into effect, U.S. oil producers have announced production curbs of their own totaling more than 1 million barrels per day, with more to come. The IEA expects that output from non-OPEC countries could tumble more than 5 million barrels per day by the end of the year.

These are massive numbers that have spooked oil prices back up to where they were in mid-April. Whether they can rally further from here in the short term remains to be seen.

After all, the prospect of inventories filling up remains a possibility with demand still in the dumps. The question is, can economies reopen fast enough, and can demand rebound fast enough, to get supply and demand back into balance before that happens?

That will determine whether the unprecedented negative oil prices seen in April will remain unprecedented.

Longer term, it looks as if oil prices will be on much firmer footing. The damage that 2020’s downturn so far is doing to energy sector investment is immense. Supply in the coming months and years will pay a price for that.

Contact Sumit Roy at [email protected]