These are unusual times in oil and gasoline markets, but not really mysterious.
Everyone has a role to play in the pandemic. My primary role – as my younger friends remind me – is to stay the hell home, and out of the hospital. Check. But the questions in my inbox lately suggest another role: attempting to explain petroleum markets, from Oklahoma crude to the California pump prices. So, cribbing from those emails, here goes…
Negative Oil Prices?!? How did that happen and what does it mean?
If you follow energy, you couldn’t have missed the excitement on April 20, when “the price of oil went negative.” There was a lot of huffing and puffing around this, most of it unwarranted.
First, the price of oil that went negative was for May 2020 delivery to Cushing, Oklahoma, known as the West Texas Intermediate (WTI) futures contract. Ten years ago, this would’ve been a somewhat bigger deal, because the WTI contract was the world’s benchmark oil price. It isn’t anymore, and hasn’t been since 2011. That was when pipeline capacity for carrying oil from the center of the continent–West Texas, Oklahoma, North Dakota, Alberta, etc–to the Gulf Coast became so overwhelmed that mid-continent oil suppliers couldn’t move all their supply. The WTI price dropped well below other world prices, and WTI became just a regional price index. While the May WTI contract went negative on April 20, the new benchmark world oil price, Europe’s Brent crude, stayed above $25 per barrel.
Second, the only contract that went negative was for delivery in May. The price for WTI delivery in June remained well above zero though still distressingly low if you were a producer, dropping near $20 per barrel.
What happened was that demand everywhere had collapsed due to the pandemic, but oil wells can’t turn off quickly. With crude oil being stored wherever there was a facility that could take it, the oil-rich middle of the country didn’t have enough space for the huge amount of extra supply there. And they couldn’t ship it elsewhere, because pipelines were at capacity. Some buyers were obligated to take oil, but had nowhere to put it, so this valuable commodity looked like it could turn into a liability. A small number of buyers panicked and started paying others to take that responsibility off their hands. By the next day, the panic subsided and the price turned positive, though still low.
It was a strange event, but it represented very few barrels of oil. Furthermore, research Ryan Kellogg and I published in 2014 suggests that the beneficiaries of even that cheap oil in the middle-US will be refiners, not consumers. Mid-continent gasoline prices don’t follow mid-continent oil prices, because gas can still move around the country (different pipelines) so the gas price still reflects world oil prices. That is, it’s Brent, not WTI, that matters to even U.S. drivers.
Are today’s low oil prices mostly due to cratering demand or to a price war among cartel producers?
OPEC Schmopec. Saudi Arabia had barely started to make good on the output increase it promised in March when it reversed course and began decreasing. This week, the Saudis announced they would decrease production to well below pre-COVID levels. Even the increase they threatened in March was less than 3 million barrels per day (bpd) in a market that started at around 100 million bpd. In contrast, it looks like world demand bottomed out in mid-April down around 30 million bpd. And it’s likely to be down 20 million bpd for the entire second quarter of 2020. Not even in its fondest market manipulation dreams can Saudi Arabia overcome being ghosted by that many buyers.
Where are oil prices headed?
Most economists start by looking at the crude oil futures market. Oil prices recovered somewhat last week, as many lockdowns were eased, with the July contract for Brent closing around $33 per barrel on Friday. Meanwhile the contract for July 2022 closed at $41, so the best guess from traders is that the price will gradually drift upward. Still, those forecasts are never very reliable, and especially right now. The single biggest factor that will determine the course of oil prices, and the economy generally, is the science of treating and preventing COVID-19. If you can predict when an effective drug or vaccine will be widely available, you can make a lot of money in nearly any asset market these days.
Why haven’t pump prices fallen as much as crude oil?
They have. The standard relationship is that every $1 per barrel drop in the crude oil price translates to 2.5 cents at the pump. Comparing to six months or a year ago, that is what has happened. A $40 per barrel crude drop since May 2019 has resulted in about a one dollar per gallon gas price decline. There is gradual adjustment in retail prices, particularly on the downside, so the change wasn’t as dramatic as oil.
In the wholesale market, the commodity price (for huge bulk purchases) of gasoline actually dropped more than the cost of crude oil for a while, because refineries were unable to ratchet down their gasoline production as fast as demand was disappearing. In fact, for a few days in April, commodity gasoline was selling for less than the crude oil that went into making it. Being an oil producer these days is pretty awful, but being a refiner isn’t much fun either. Refineries have now reduced their throughput and refinery margins on gasoline have improved.
The MGS is alive and well, I’m sorry to say. But it has declined a little bit in recent weeks. As of this morning, California’s average pump price is $1.01 above the rest of the country. About $0.71 of that can be directly tied to higher taxes, environmental fees, and our cleaner burning gasoline. The MGS is the difference, about 30 cents. At normal consumption levels that would mean Californians would pay an unexplained extra $4 billion per year. It will be a bit less this year, but is still on track to be north of $3 billion.
The AG’s announcement was interesting, but it isn’t likely to explain much of the MGS. The case they announced was for behavior in 2015 and 2016, and it was for activities that raise the commodity price. As I have discussed in a previous blog, that’s not where most of the MGS has come from in the last few years. The AG said that the investigation continues, which I was pleased to hear.
Why is the federal government bailing out oil U.S. producers? If the point is to help workers in the industry, why don’t they just help the workers directly? Especially in an industry where a small share of revenues go to labor and most of the benefit of the bailout will go to shareholders?
I’m still tweeting energy news stories/research/blogs most days @BorensteinS
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Suggested citation: Borenstein, Severin. “Petro Questions and (Some) Answers” Energy Institute Blog, UC Berkeley, May 18, 2020, https://energyathaas.wordpress.com/2020/05/18/petro-questions-and-some-answers/
Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. He chaired the California Energy Commission's Petroleum Market Advisory Committee from 2015 until its completion in 2017. Currently, he is a member of the Bay Area Air Quality Management District's Advisory Council and a member of the Board of Governors of the California Independent System Operator.