WEEKLY E-MAIL

27 April 2020

WHAT IS GOING ON WITH THE OIL PRICE AT PRESENT?

By Paul Nicol

The oil price started falling on 7 March 2020 when Russia and Saudi Arabia failed to reach an agreement regarding production cuts. Subsequently, Saudi Arabia cut prices and announced an expansion in production to 12.3 million barrels per day, an increase of approximately 25%. This occurred just as the true magnitude of COVID-19 was being felt by Western countries, raising the eyebrows of market watchers. Subsequently, it is now estimated that the global demand for oil is down about 25%, or 25 million barrels per day, reflecting the substantial reduction in vehicle mileage and the virtual cessation of international passenger aviation globally which of course are heavy uses of fuel.

In early April, OPEC members and its allies finally agreed to slash global output by about 10%, but stresses in the oil market were already obvious with a significant build-up in oil stockpiles over the recent period as demand slumped. Some producers, especially the ones without the ability to load onto seagoing tankers, now face the prospect of completely full storage capacity, which could result in them having to shut off production.

As a result, oil prices have crashed. The panic selling in oil prices was exacerbated by May futures, which mostly due to a short maturity date, hit a low of -$40.32 on Monday 20th April. But, putting the technical quirks of futures contracts aside, the June contract with a longer maturity date on Tuesday 21st April briefly dropped as much as 42% to $11.79 a barrel which is absolutely astonishing.

The domestic US oil industry is being particularly hard-hit by these pressures, which most likely explain President Trump’s intervention announcement on Wednesday 22nd April to buy oil for the country’s national reserve. But concern continues to mount that storage facilities in the US will run out of capacity, with stockpiles at Cushing, the main delivery point in the US for oil, rising almost 50% since the start of March.

WTI price (US$ per barrel)

The immediate and obvious impact in the collapse of the Oil price is for marginal producers, particularly U.S shale. Put simply, the smaller high-cost producers of U.S shale are uneconomic at these prices and are now being shut off from capital. With shale producers losing money at these prices and unlikely to be able to fund themselves for much longer, so there is potential for widespread bankruptcies in the U.S shale industry.

But, of more particular concern is that the oil market is symptomatic of a pronounced demand/supply imbalance that underscores the turmoil caused by severe and sudden stops in economic activity due to COVID-19.

It is likely we are going to see the same theme of severe demand/supply imbalances surface across many other markets and industries in the coming months. The slowdown of economic activity in a normal recessionary cycle is more gradual, which means companies have at least some time to adjust by reducing output in an orderly way, shoring up their finances and preparing their workforce. Unfortunately, COVID-19 has been sudden with no time to prepare.

Unfortunately, the volatility in oil prices is the likely pre-cursor to significant volatility likely to appear in other areas of the Global Economy. Any way you look at it, the recovery from COVID-19 is going to be long and slow as significant demand/supply imbalances takes time to repair.

Paul Nicol

Managing Partner
Senior Financial Planner
SMSF Specialist Advisor™
Barron’s Top Financial Adviser 2017, 2018 & 2019
Authorised Representative No. 230876

If you have any questions or comments, please email me at paul@gfmwealth.com.au

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