Mark J. Terrill/AP Photo
The oil tanker Pegasus Voyager off the coast of Long Beach, California
The price of oil is an abstraction. When it plummeted to -$37/barrel on April 20, we can be sure that not many actual barrels of oil in physical markets traded at that seemingly irrational price, though some were offered at prices below zero. That plunge was in the price of a hypothetical barrel of crude oil represented in a financial instrument, a derivative traded in financial markets like the New York Mercantile Exchange (NYMEX): the West Texas Intermediate (WTI) Light Sweet Crude Oil futures contract for delivery in May. Clearly, the trading that influenced the movement of prices is by speculators who had no intention of taking the oil.
In principle, the WTI futures contract represents 1,000 barrels of WTI crude oil, a type of crude oil considered high-grade because it is low in sulfur (sweet) and low in density (light), which makes it easier and less costly to refine compared with other types of crude oil. It is used as a benchmark against which other types of crude oil are priced in spot, or physical, markets in the U.S., where actual oil is traded, at a premium if they’re lighter and/or sweeter, or at a discount if they’re heavier and/or more sour. (There are other benchmarks in other markets, most notably Brent crude, which is extracted offshore in the North Sea and used as an international benchmark for almost two-thirds of oil traded in the world.) The derivative gives its owner the option either to buy 1,000 barrels of WTI crude oil at a price determined in advance on the day of its execution, or to settle the contract for the difference between the price specified in the contract and the price of oil on the day of its execution. If the price set in the contract is lower than the price of the hypothetical underlying commodity on the day of its execution, then the owner makes a profit without touching the oil, or vice versa. Most oil futures, and other oil derivatives, are settled in this way, for a price differential.
When traders last Monday sold WTI futures contracts for -$37/barrel, they effectively paid the buyers of the contract $37 per barrel to take the responsibility for the oil delivered in Cushing, Oklahoma, on Tuesday, April 21, the settlement day for the WTI May contract. The owner of the contract lost money certainly, but it was the price of unloading the contractual obligations onto the new owner of the contract and the commodity underlying it.
Traders seem more optimistic about the distant future than the near future—they are not concerned with the present.
The fact that oil prices are measured according to types of crude oil that represent insignificant shares of the market reflects the influence of financial markets on determining the price of oil in actual markets. Trading in oil futures on financial markets emerged out of the 1979 oil crisis and the subsequent liberalization of the oil market: the expansion of trade in spot markets outside long-term, fixed-price contracts. The introduction of oil derivatives on the NYMEX in 1983 and on what was then the International Petroleum Exchange in London in 1988, and the expansion of trade in multiple forms of energy-related derivatives following the Gulf War of 1991, expanded the oil market beyond physical markets and provided oil traders with hedging opportunities against market volatility and price risks. Trading in financial markets, however, became itself a source of volatility as soon as oil derivatives became instruments for speculation on market price and market volatility, making physical oil markets, and oil production, susceptible to the reactions of traders in derivatives to any events that might impinge on the price or availability of oil in the future. The relationship between the prices of “paper barrels” traded in financial markets and “wet barrels” traded in spot markets—as the relation between the two markets—is neither linear nor univocal. Many kinds of traders trade in oil futures, including large oil producers and consumers of crude oil, who buy them to hedge against anticipated price changes. These traders, like refineries and oil companies, often buy the actual oil underlying the futures contracts, guaranteeing prices set in advance, but they also settle them financially on occasion. They profit if the price rises, and they don’t if it goes in the opposite direction. It’s a bet either way. But there are speculators who are not at all interested in the commodity itself but in the difference between current and future prices.
Speculators always settle oil futures financially rather than in spot markets. They account for the bulk in trading in financial markets. WTI is the most actively traded oil derivative on the NYMEX: Around 1.2 million WTI contracts exchange hands daily—equivalent to 1.2 billion barrels of oil per day, around 12 times daily global consumption. Speculators must settle their contracts financially—they have no other choice—and it was those speculators who frantically sold the expiring WTI May contract on Monday, forcing the price of the derivative into negative territory.
The price of oil is therefore largely determined by speculation in the futures market; yet, it reflects perceptions about the future state of the actual market. Both kinds of traders—buyers and speculators—base their activities on the future outlook of actual oil markets and on events that might influence the supply and demand of oil in various markets: economic growth or lack thereof in oil consuming countries; exceptionally hot summers or exceptionally cold winters; extreme weather events in oil-producing regions; wars and other military conflicts that might disrupt supplies, or prevent them from reaching markets, or curb the access of oil companies to upstream investment; strikes by oil workers; political instability or expansion of state control over the industry in oil-producing countries; attacks on oil production facilities and transportation and export infrastructure; and so on. In a globalized oil market, any event anywhere can influence reaction in financial markets at a speed that is impossible in actual physical markets. The more financial markets have become computerized, reliant on models and algorithms, that speed has become virtually infinite.
The prospect of war is more profitable than war itself.
A perennial event, which seems to be a favorite among oil-futures traders, is the threat of a U.S. war with Iran; every time a U.S. president threatens military conflict with Iran, traders respond positively. Trump’s recent threat to attack Iranian boats in the Persian Gulf boosted the price of WTI June contracts by about 20 percent on April 22, to close at $13.78/barrel and by another 20 percent a day later to $16.50/barrel. It is immaterial if this threat is ever realized—in the time-space of financial markets it has already happened, and the prospect of war is more profitable than war itself. The price of oil in the present reflects and is determined indirectly by predictions about the future. Financial markets bring the future into the present.
The current plunge in the oil price is a reflection of perceptions about the future, namely the return of levels of demand for oil and oil products felled by the measures taken by governments and businesses to curb the COVID-19 pandemic. Measures such as social distancing, quarantines, and lockdowns have slashed consumer spending on nonessentials and on big-ticket items; closed down factories and hotels, places of work, and places of leisure; and have led to massive unemployment. It was mostly the reduction in commuting and car travel, reduction in seaborne trade, and the near cessation of air travel that had the most direct effect on the demand for oil and on the plunge in the oil price. Around 60 percent of crude oil in the world is consumed in the production of transportation fuels.
The demand for oil has declined by around 30 million barrels per day in April, around a third of global oil consumption of 100 million barrels per day. It is not so much the current lack of demand, however, as much as uncertainty about demand for oil in the future—uncertainty about when economic activities, travel, and international trade will return to anything close to their pre-pandemic level that is reflected in the current price, in other words, the price of oil futures.
Traders seem more optimistic about the distant future than the near future—they are not concerned with the present: WTI November contracts have traded at around $32/barrel last week and May 2021 contracts at around $35/barrel. Almost everyone in the industry, however, agrees that even if such demand is to return it will be a very slow process—too slow for producers to slash production accordingly—and some even doubt if pre-pandemic levels of oil consumption will ever return, speculating that the current measures, not to mention an impending recession, may have established alternative modes of life for most people across the world. As long as the expectation is for demand to remain low and slow to recover, prices will remain depressed for the foreseeable future and volatility in the financial market quite high. Which means investment in exploration and production will probably decline, presumably slowing down production and easing the crisis of demand.
Paul Sancya/AP Photo
The Marathon Petroleum Corporation refinery in Detroit
The plunge in demand, however, did not in itself, or by itself, cause the decline in the oil price.
The reduction in the demand for oil has occurred in an already oversupplied market reeling from a price war between two of the world’s largest oil producers, Russia and Saudi Arabia. Saudi Arabia and Russia ended their feud on April 12 and reached an agreement with the U.S. and 20 other oil-producing states to reduce production collectively by 9.7 million barrels per day. Although no one expects such a modest move to affect the oil price in the short term, the oil price did recover a little following the agreement before it continued on its downward trend. Traders know that the presumed reduction, which is supposed to take effect on May 1, is not enough to ease the growing oil glut, which is increasing at a rate three times the cut. Besides, historically such agreements have not been always honored by all parties.
The world is running out of space to store crude oil, and oil traders have been scouring the Earth for potential storage sites.
Even if no one cheats, there is no guarantee that a reduction in production will automatically prop up prices: Almost immediately after the agreement was reached, Saudi Aramco slashed its crude-oil selling price to maintain its market share. More to the point, and contrary to what orthodox economists and energy analysts profess, the price of oil is not directly determined by supply and demand in physical markets.
The current crisis is mainly a crisis of overproduction reflected in the rapid exhaustion of crude-oil storage capacity. The world is running out of space to store crude oil, and oil traders have been scouring the Earth for potential storage sites, including shuttered refineries that went out of business after the last oil price crash and obsolete tankers bound for the salvage yard. Some pipeline networks have become storage containers. Tank farms and the tanks of refineries are already full. Refineries have stopped buying crude oil anyway because they have stopped refining it: There is already a glut of gasoline, diesel, jet fuel, and other oil products on the market. The problem is worse in regions without access to tankers that are now functioning as floating reservoirs. But tankers, supertankers, and VLCCs (very large crude carriers) have been also filling up rapidly, commanding high rents for their owners—perhaps the only segment of the sector that is capturing profits at the moment. They are sailing aimlessly or berthed in ports from where they can reach markets in Asia and Europe more rapidly when demand for oil returns. The shortage of storage space is global, but it is especially acute in the U.S.: Around 60 percent of global storage capacity (6.8 billion barrels) is filled, but oil storage capacity in the U.S. is fast reaching its absolute limit. And because it wouldn’t be the oil market if it lacked in absurdity, supertankers filled with Saudi oil are heading to Houston to flood the U.S. market with more oil.
The glut is partly, but significantly, the result of the increase in production of unconventional oil from shale formations and oil sands in the U.S. and Canada over the past decade, most of it by smaller independent oil producers, the mainstay of the oil industry in the U.S., and much of it financed by debt and financial trading. For several weeks before the WTI May futures contract plunged below zero, the situation in physical markets was worse than it was in financial markets. Oil traded at prices in the single digits in some regional markets in the U.S. and Canada.
Charles Rex Arbogast/AP Photo
Oil tank train cars sit idle in East Chicago, Indiana, April 21, 2020.
It is comparable to the situation in the summer of 1931 following the discovery of large oil fields in East Texas. Hundreds of small oil producers then outcompeted each other in flooding an already glutted market in the middle of a recession, destroying the oil price across the country and eventually forcing the state to declare martial law and send in the troops to curb production. Oil traded at 7 cents per barrel in July 1931, in some places even less, when its cost of production was 75 cents, leading The Wall Street Journal to declare in its July 9 issue, “East Texas Oil Breaks the Market.”
In the middle of April this year, West Texas Intermediate traded at around $10/barrel at Midland, Texas, the center of the boom in shale oil in the Permian Basin, where its cost of production is between $26 and $32 per barrel; Wyoming Asphalt Sour crude was bid at “less than zero dollars,” per the Journal. At current prices, many small oil producers will not be able to make interest payments on their debt, let alone make profits, forcing them out of business.
Yet, we should not expect production to slow down at the same pace and to the same extent as the decline in demand.
Some small independent producers, and some larger independents, have already shut in productive wells; large, publicly traded oil and oil service companies have cut down on drilling, slashed their budgets, and postponed exploration and production projects—not only in the U.S. but in other regions also, notably the North Sea. Undeveloped oil fields will probably remain undeveloped in the near future. At current prices, investments in regions where extraction costs are high, like the North Sea, the U.S., Canada and elsewhere, are certain to decline. Investment in high-cost regions has already declined since the last oil price crash of 2014, and the current collapse in price has only made those regions more unprofitable and will likely shift investment capital to other regions. Indeed, the current crisis might accelerate the shift of investment capital away from oil and other fossil fuels altogether to alternative and renewable forms of energy production.
Oil producers have to keep producing oil because they have invested so much capital in its production.
There are factors, however, that impede any meaningful reduction in production. In the first place, there are technical impediments involving shutting in wells and turning them off. Once an oil well comes online, shutting it in becomes expensive and would risk damaging it or impairing its productivity, especially shale oil wells. Bringing an oil well back online is also expensive if at all viable: There is the risk that it might not become productive again or as productive as it was before. Those technical difficulties are exacerbated by the nature of the market: No producer wants to be the first to cut production and give up market share—this is the problem that plagued the oil industry in the U.S. in the 1930s and that has plagued OPEC since its inception.
Moreover, oil producers, especially small independents, rely on debt to finance their operations, and they must keep some wells in operation at least to service their debt even if profitability declines. Publicly traded companies, on the other hand, have to keep investing in their core operations because their market valuation depends on perceptions about their future growth and profitability. And all have to pay royalties or some form of rent. Oil-producing countries with state-owned oil companies have the additional burden of state budgets that rely on oil sales and taxes and royalties from oil production.
The most important factor militating against reductions in production is the valorization of capital fixed in production, refining, and transportation of oil and oil products—not to mention the potential value of the oil reserves themselves and the rent they command. The chronic tendency in the oil industry toward overproduction, as in other capitalist industries, has its origin in the progressive growth of fixed capital in absolute terms and in relation to labor costs. Larger quantities of oil have to be produced to valorize the capital fixed in its production, to realize returns on investments.
The computerization and automation of oil extraction, a process that also began in the 1980s and which has led to massive layoffs in various segments of the oil industry since then, has made a capital-intensive industry more capital-intensive. This is particularly the case in unconventional oil production, but it is a general aspect of the whole industry. Large amounts of capital invested in the means of production have to be valorized, employed to produce more value, at the risk of depreciation. Idle capital is an active and passive waste of value. The means of production have to be maintained at a cost to protect the value already fixed in them lest they fall prey to processes of physical decay and depreciation arising from the development of cheaper and more productive technologies by competitors.
In short, the strongest demand for oil derives from the imperatives of capital accumulation, namely the protection and augmentation of the value of capital invested in oil production. Oil producers have to keep producing oil because they have invested so much capital in its production; the more capital they invest in it, the more oil they have to produce to recapture their investments. If this sounds tautological, it is, because the object of capital accumulation is the accumulation of more capital. The irrationality of it all is that amid a massive and growing glut of oil, and reduction in demand for it, oil producers will continue to pump it out of underground reservoirs only to store it in aboveground reservoirs in the expectation that someday it will be sold, refined, and burned, ending up finally in the atmosphere. The current glut in the oil market must be regarded as a global oil spill and should be addressed as such. The only effective way to curb an oil spill is to prevent it from happening in the first place, to keep the oil in the ground.
