Negative Prices Should Not Lead to Negative Policies

On Monday we saw an unprecedented event: the price for the May futures contract for West Texas Intermediate (WTI) oil dropped below zero, reaching as low as minus $40 per barrel.  The event sparked a surge of commentary from people unfamiliar with oil markets or even downright celebrating the prospect of job losses.  Without going into whether these folks are just ignorant or are deliberately misleading their followers, let’s be clear about what really did happen and what that means for energy policy.

What really happened

To begin with, a barrel of physical oil was never selling for a negative price.  The physical oil changing hands yesterday (e.g. sold to a refinery) was certainly transacting for low prices compared to the beginning of the year, but not negative.  What was trading for a negative price was the futures contract for May delivery of WTI oil to the hub at Cushing, OK. These contracts expired on Tuesday. Anyone still holding the contract on expiration is committed to receiving the contracted amount of physical oil in Cushing in May on the date specified in the contract.

But futures contracts are widely traded derivatives; numerous entities like banks, brokerage houses, and even retail investors buy and sell these contracts.  None of these entities are set up to receive physical oil, they are betting on the price of oil rising or falling. So when the contract expiration approaches, these trading entities need to sell off their contracts to entities that are capable of taking physical oil either for use or for storage.  This is where the negative price comes into play: as traders scrambled to unload their futures, there were no buyers, or at least no buyers at positive prices. What these negative prices signaled is not that oil was valueless, but that storage in Cushing was fully (or nearly fully) contracted.

Fully contracted does not mean actually full, physical traders of oil maintain long term contracts for storage space for precisely this kind of eventuality.  Those physical traders with contracted storage made a good profit on Monday being paid to take oil from desperate futures traders. The volumes of futures being traded Monday were fairly small, indicating that a few speculators probably were gambling on better economic news and got caught out, so it is hard to say for certain how full storage is, but the price falling so low is a signal that storage in Cushing for May is going to be very tight.  This is hardly surprising given the massive hit to demand we have seen from the shutdowns due to the Wuhan coronavirus pandemic.

While negative futures prices are unprecedented, it is actually a sign of the oil markets working as intended.  As the pandemic shutdowns have rippled across the US and suppressed short term demand, many oil traders have turned to storing oil to sell later this year when the economy opens back up and demand returns.  The market is now signaling to traders and producers that Cushing is filling up. This means reversing pipelines from Cushing, looking for new storage locations, or reducing new production. All these adjustments have been underway already, these negative prices are telling the market participants to speed up the pace of their adjustments.

What it means

All that said this is still a very concerning development for the US oil industry.  The world is awash in crude oil right now from the only recently paused price war between Russia and Saudi Arabia.  That supply glut has been combined with a massive demand drop as economies around the world have been shut down. Storage has been able to absorb US production so far, anticipating demand rebound later this year, but there is only so much storage.  As it fills up, US producers will be forced to slow the pace of their production, hitting their bottom lines and leading to layoffs among the millions of jobs directly and indirectly tied to the industry, which makes the celebrations from some quarters all the more ghoulish.

Importantly, though, this is a short-term shock.  US producers will rein in production in the near term, and that adjustment will be difficult, but demand will eventually return.  What cannot happen is for policy makers to respond to this short-term confluence of events with actions that do long term damage to the competitiveness of the US oil industry.  Too many of the policy responses thrown out have smacked of central planning: government set production cuts, tariffs on imports, preventing ships from unloading imported oil, paying producers not to produce.  These are precisely the wrong responses, a dynamic, innovative and flexible oil industry will best be able to rebound when demand returns. A coddled, subsidized industry with government trying to artificially prop up prices won’t.

There are certainly things that government could do to help get through this crisis.  Renting storage space in the Strategic Petroleum Reserve, relaxing regulations that impede conversions of new storage, waiving steel tariffs that unnecessarily increase the cost of drilling and transportation, waiving the Jones Act which raises the cost of moving oil around the US.  All would be welcome policy actions, and importantly they would be positive actions in their own right, independent of the short-term crisis.

The ultimate solution for the oil industry is getting the economy back open and running again.  We have seen hopeful signs in the last week, as some states and countries have begun partial re-openings.  Oil is not valueless, it is still the commodity that powers the world and the feedstock for most products we use every day.  When the economy rebounds, oil will rebound. Policymakers need to recognize this simple truth and avoid knee jerk reactions to short term factors that will harm the industry in the long term.

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