Oil wealth crisis

by April 23, 2020 0 comments

The outbreak of Coronavirus is changing the nature of everything. What’s sure is that the energy industry will never be the same again. But why did this happen? Let’s take a quick primer

As West Texas Intermediate (WTI) crude prices collapsed into the negative territory in an afternoon of frenetic trading, far too many assumptions were made about oil prices. Crude prices plunged below zero to touch a historic low of -$40.32 per barrel. Before anything else, one has to understand the basic nature of commodity trading, which is that, at the end of the day, a physical product has to be delivered and one has to accept this. The seller does not care what the trader or the buyer does with the finished product. Now, WTI crude, which is produced mainly in what we call the “Texas panhandle,” is unique in the sense that it is delivered in one location, which is the town of Cushing in the US state of Oklahoma. In pre-COVID-19 times, the crude was delivered, the buyer accepted it and he/she carted the crude away to a refinery for it to be processed. Cushing, with a crude oil storage capacity of around 70-80 million barrels, never saw storage fill up.

But these are not normal times, the storage capacity at Cushing is almost full today. And with the Coronavirus-imposed lockdown, oil consumption is minimal. According to one estimate, of the 100 million-odd barrels being used up daily before the COVID crisis, some 30 per cent is no longer needed. No planes are flying; there are hardly any cars on the road; there are fewer ships and less consumption of oil-derivative products such as plastics and other polymers. Global oil consumption, which was around 95-110 million barrels of crude oil almost every day before the virus hit, is now barely a third of previous consumption, if not less.

Here is the critical thing to understand about crude and its production: An oil well is not like a water tubewell. You cannot just “switch it off.” Moreover, the physical characteristic of crude oil is more akin to tar than petrol. While there are exceptions, Brent crude is particularly light and the most preferred one by oil refineries. Most crude oils are thick and if not kept at a certain temperature and pressure — which is why many oil wells use steam to force crude out — will quickly turn into a thick sludge and at lower temperatures, solidify.

Simply put, “switching off” an oil well will almost certainly make the crude useless. Even if it recovers, it will cost both money and time to do so. Most of the time, oil companies will need to spend months to redrill the same well. Thus, this limits the amount oil producers can drop. Most oil wells can only reduce production to maybe half, sometimes less, depending on the characteristics of the crude being extracted.

If Saudi Arabia and Russia could stop production, they would, but the fact is that they cannot. The same holds for shale fracking, which is popular in the US. Stop, and the hydraulic fracturing will close. So you cannot “turn off the taps” for any sort of oil and gas production. And right now, production, even at reduced numbers, is far exceeding demand. While there are no proper estimates, over-capacity is in the range of 50-60 million barrels per day, according to the most pessimistic numbers.

You cannot just burn the oil off, that would just give Swedish environmental activist Greta Thunberg an opportunity to make it back into the headlines. You store the oil but with the world going into the second month of reduced consumption, the fact is that we are running out of storage space.

Almost every country has filled their strategic oil reserves to the brim and oil traders are running around across the world, trying to find large storage tanks. So much so that old, dilapidated oil tankers are being brought out of mothballs and anchored just to store crude oil. Large fuel tank “farms,” as they are called near ports and refineries, are full. Farms are being rediscovered in the strangest of places. There have been requests to reopen storage facilities in Zimbabwe, for example.

So with nowhere to store the crude oil, what does a buyer do? He/she would obviously try to get rid of that oil, to the extent that they would pay someone to take

the oil. And yes, we could look at trading algorithms going crazy but in essence, that is exactly what happened with WTI.

Now, other types of crude, like Brent, allow you to take delivery anywhere. This is the reason why they were not hit by the lack of storage capacity in one town. But any oil trader will tell you that while you could find maybe a couple of million barrels of storage here and another five million there, the world is almost out of places to store crude oil — on land or offshore in supertankers.

The “delta”, which is the difference between the prices of WTI and other types of crude, is too high to be sustainable.  Therefore, people feel that all types of crude oil prices will collapse, whether oil producers like it or not. Already, Brent crude, which fell 24 per cent in the previous session, touched $15.98 a barrel, its lowest since June 1999.

With nowhere to store the oil, the prices of Brent crude may also go in the negative, if not this week, definitely by the end of the month. No matter how you slice it or dice it, global demand is not going to recover anytime soon, maybe not until the middle of 2021. Oil prices have slumped by around 80 per cent this year as the pandemic has spread across the world. The viral outbreak has caused fuel demand to drop by roughly 30 per cent worldwide.

But is this a golden opportunity for India? No. Our country, too, is running out of storage space. There are no tankers left to store crude, our strategic reserves are full and current demand is abysmally low. Sure, there could be a slight decrease in pump prices even with far higher excise duties, but the oil business, as we have known it from the time of the 1973 oil crisis after the Arab-Israeli Yom Kippur war like so many other things, is never going to be the same again. What this means for the petrodollar economies of Saudi Arabia and the rest of the Arabian peninsula is something that will now have to be added to the geopolitical chaos that the virus has wrought on the world.

(Writer: Kushan Mitra; Courtesy: The Pioneer)

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