Question

Energy markets are flashing a warning: The world is swimming in crude oil, and the glut won't drain away any time soon.

Twin shocks -- the coronavirus pandemic and the breakdown of Russia's partnership with the Organization of the Petroleum Exporting Countries -- threaten to flood the market with cheap oil at a time when demand is falling.

That has caused the relationship between oil prices at different dates, a closely watched barometer of the balance between supply and demand, to indicate a severe surplus of oil is imminent. On Thursday it cost around $31 to buy a barrel of Brent crude for next month, $8 less than it cost to buy a barrel for April 2021.

This gauge was last as extreme in early 2015, when oil production was soaring in the U.S.

"This is a once-in-history demand shock being met by a once-in-a-generation supply shock going the other way," said Saad Rahim, chief economist at commodities trader Trafigura. "This virus is directly affecting travel and movement in a way we've not really seen before."

Global oil inventories will expand by nearly 1.4 billion barrels between March 2020 and August 2021, analysts at Standard Chartered estimate. This number of barrels contains enough oil to fill 88,000 Olympic swimming pools, which would stretch from New York to San Francisco if they were lined up in a row.

Oil prices took another hammering Thursday, after President Trump Wednesday announced a 30-day ban on some travel from Europe into the U.S. Brent-crude oil, the global benchmark, dropped 6.7% to $33.37 a barrel, while U.S. crude futures fell 6.1% to $30.98 a barrel. Both benchmarks have lost almost half their value in 2020.

"Markets are screaming for OPEC not to flood the markets," said Hakan Kaya, who manages commodity investments for Neuberger Bermann. "The signal is loud and clear to OPEC and U.S. producers: just don't bring the additional barrels of crude oil -- it's not needed."

The change in pricing of oil in futures markets represents a major shift into what traders call contango, in which traders can buy cheap oil today and lock in a higher price for selling at a later date. Buyers and sellers of oil use futures, a type of contract, to lock in prices, protecting them against swings that take place between signing a deal and exchanging the crude.

"The textbook reason for why you get this steep contango is that you have to incentivize people producing oil to store the oil now, as opposed to sending it out into the market," said Michael Haigh, head of commodities strategy at Société Générale.

The shifting structure of the oil market is likely to create new winners and losers.

Shipowners are one possible beneficiary. The cost of chartering vessels used to transport crude has surged, pushing the Baltic Dirty Tanker index up 38% this week.

"What we have started to see is owners pricing in the risk of freight rates moving up and the potential for floating storage too," said Claire Grierson, head of tanker research at shipping brokers Simpson Spence Young.

If the gap between near-term and long-term prices remains as wide as it was this week, companies with large physical trading operations such as Trafigura Group and Vitol Group could also make easy money.

The oil market has been struggling with excess supply since long before the outbreak of the coronavirus. OPEC cut its forecast for demand growth in a monthly report this week, the seventh time it has done so in the space of 10 months.

"Even in December, we knew that this year's supply was going to overrun demand," said Marwan Younes, chief investment officer at Massar Capital Management, a New York-based hedge fund. "It's gone from bad, to very bad, to extraordinarily bad." he said.

Saudi Arabia and Russia have both said they would open their spigots when the agreement to cut production expires on April 1. Investors say the gap between oil prices at different dates could continue to widen when the consequences of those decisions become more apparent in the actual physical movement of oil around the world, according to Richard Fullarton, chief investment officer at Matilda Capital Management, a London-based hedge fund.

1. Draw and label a graph illustrating the demand for and the supply of oil. Indicate in the graph the location of the equilibrium point. Explain why it is a mistake to state that at this point: “the demand for oil is equal to the supply of oil.”
2. Refer to the graph you drew for the previous problem. In the graph illustrate the impact of a decrease in demand and an increase in supply. Briefly explain why the net effect of these two changes on the equilibrium quantity of oil is uncertain.
3. From the article: “The world is swimming in crude oil, and the glut won’t drain away any time soon.” Describe the relationship between quantity demanded and quantity supplied when there is a glut in the market for oil.
4. In the article the chief investment officer of Massar Capital Management stated: “Even in December, we knew that this year’s supply was going to overrun demand…It’s gone from bad, to very bad, to extraordinarily bad.” For whom is this change “very bad”? For whom would this change be very good?

Answer 1

1.

The oil industry is dynamic, with many individual components and teams. As in every free market, normal supply and demand rules come into effect, but each is influenced by the factors that make up the oil sector, such as production capacity, energy supplies, and international relations.

So, normal demand and supply rule doesn't apply for the Oil market.

2. A decrease in consumption and a rise in supply would induce a decline in the price of equilibrium, but the impact on the quantity of equilibrium can not be calculated. Consumers now put a lower premium on the good for every amount, and suppliers are able to tolerate a lower price; hence output must decline. The effect on performance depends on the specific size of the two modifications.

3. Each moment there is an excess, the demand declines until the excess goes out. If the excess is removed, the produced quantity is only equal to the desired quantity — that is, the volume that manufacturers wish to sell is precisely equal to the volume that buyers want to purchase. They call it harmony, which implies "balance"

4. For customers, this high supply and low demand scenario are very good as this change will bring the prices of the oil down.

On the other hand, for oil companies, this can be very bad. Also, for oil-producing countries like the middle east Arab nation will face a severe slowdown in the economy. Also, many people will lose jobs.

Declining fuel rates mean lower shipping costs and cheaper fares for airlines. Since many synthetic chemicals are produced from crude, the production industry profits from the high oil prices. Until the boom of the U.S. oil supply, declines in oil prices were largely seen as beneficial as it decreased imported oil prices and cut processing and shipping costs. The cost savings should be reflected in the price. Higher discretionary taxes will help stimulate the economy for consumer buying. But now that the U.S. has expanded energy supply, low oil prices will harm U.S. oil producers and impact workers in the domestic oil industry.

U.S. shale rock discovery and development has been a major source of employment growth. The hydraulically fractured wells appear to have a shorter lifetime of output, so there is always a new practice of exploration to locate the next deposit. All of this includes jobs for drilling crews, loader workers, truck drivers, diesel mechanics, etc. The workers working in these places also help companies surrounding them, such as hospitals, restaurants and car dealerships. Lower oil costs mean less drilling and exploration operation as much of the new oil fueling the industry is intermittent and has a higher cost per barrel than traditional oil supply. Less operation can result in unemployment that would affect the nearby companies that were working for these jobs. The adverse effect would also be deeply felt in the fracking states, particularly through some of the positive effects of falling oil prices that continue to appear in other areas of the United States. It is regionally costly for the world, and the results show in figures on state-level unemployment.
Such reductions, though, do not have a significant effect on national numbers of unemployed.

The key sectors that continue to deal with declining U.S. oil prices are the banking and mining industries. In the shale fields, there are several various firms exploring and operating wells, and all of these firms finance their activities by generating money and taking on debt. This suggests that both creditors and banks have billions to lose if oil prices decline to where new fields are no longer viable and the exploration and service-dependent businesses then go out of business. Of course, creditors and banks are well versed in risks and benefits, but when they do happen, the losses always kill money. Among employment losses and capital losses, a decline in oil prices will buffer the US economy's rise.

Low oil costs often benefit shipping firms, but again the profit is blurred due to pandemic 'broader economic implications. Gas – usually petrol – pays for a significant proportion of freight transport prices, but it is typically passed down to end consumers who buy goods such as supermarkets and other shops.

One hypothesis is that Molchanov floating of fuel-intensive shipping would be more desirable than less fuel-intensive forms, such as air freight and trucking. That's how the cheap oil would make the more gas-intensive modes less costly on a relative basis.
The market might change as more fuel-intensive options would face comparatively greater discounts (i.e., maximum freight bill costs) compared to less fuel-intensive modes, which in effect might potentially restrict rail and (specifically) the value proposition of intermodal as a substitute to trucking.
It will help freight businesses that use trucks such as Werner Enterprises while damaging rail firms such as Union Pacific and Berkshire Hathaway-owned BNSF.
Natural gas is another field which has benefited from the low oil prices. Over the last couple of years, gas drillers have been harmed as oil drillers generate a ton of "natural coal" which has produced a surplus of coal in the market. With oil prices dropping, oil drillers are slowing production and therefore taking off the market the "linked petrol." Some analysts think that prices for natural gas could double over the next year. Gas manufacturer EQT will be amongst the winners