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Crash in oil markets just the first domino to fall

by Taha Meli Arvas

Apr 23, 2020 - 12:05 am GMT+3
by Taha Meli Arvas Apr 23, 2020 12:05 am
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If you’ve been following the news lately, crude oil is trading at all-time lows. Specifically, West Texas Intermediate (WTI) crude, or the type of crude oil most traded in the United States, traded at negative prices for the first time in its history. This means the owner of the contract, the one that was actually receiving the delivery of the oil, not only didn’t pay anything for it but was paid to take the delivery. How is that possible? Let me catch you up to speed and explain why this one event may likely be the credit crisis that pushes the post-coronavirus world into a deep depression.

In early March, Saudi Arabia and Russia got into a fight. The Saudis wanted to cut the production of oil so as to increase prices, but the Russians didn’t. Things came to a head at the OPEC+ meeting, and Saudi Arabia, in an apparent attempt to spite Russia, voted to increase production. They had two motives for this move. One, an increase in production would cause oil prices to plummet even below the cost of production for the Russians, forcing them to keep pumping oil at a loss. Two, the U.S. shale gas producers, whose costs of production are even higher than the Russians’ conventional oil drilling, would be hurt even more by this collapse of prices. The Saudis would wait out the U.S. producers and punish the Russians. The U.S. producers would go bankrupt, exploration would stop and the Russians would learn not to mess with the Saudis again. Enter the novel coronavirus.

No one could have seen the effects of the coronavirus coming. A complete and utter stop to consumption? To shipping? To flights? A tail event for sure. But this is what happened, and oil kept dropping way below what the Saudis had anticipated. The Russians got the message and the Saudis and Russians agreed to reverse course a month after their falling out. But the damage was done. During the monthlong spat, oil was so cheap no one thought it could go lower. Many sold futures for delivery several months down the line and bought crude at spot prices factoring in the cost of carrying the oil until then and making the delivery. Then, everyone else began doing the same thing. Suddenly there was nowhere left to store the oil that everyone had bought. No one was using the gas that had been produced from the crude oil and suddenly everything stopped – everything except oil production. You can’t just turn off oil production and turn it on the next day. It takes days or weeks to turn back on and weeks to “shut off.”

So oil kept pumping, storage tanks are all full, and people are getting paid to take away the oil. That’s where we are now. The U.S. shale gas producers used low-interest loans and sold bonds at relatively low rates to finance their operations to the tune of billions of dollars. As the price of oil kept falling, they began defaulting. The Federal Reserve and U.S. government stepped in to help save them from default but many have already gone bust with many more losing money every day in anticipation of a turnaround. Investors who lost money with these companies are selling off other assets as they turn to liquidity, and this is depressing prices of other assets. If this continues, everything is going to sell off and we’ll be back to 2008 or worse in short order.

The world will have to “reopen” very shortly here. By the end of May, I predict nearly all countries will have “reopened” but the loss of life will continue. Demand won’t snap back to pre-corona levels and this economic malaise will continue until some other catalyst comes along to shock the global economy back to life.

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