Coronavirus has exposed just how broken Big Oil really is

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When James woke up on Monday morning, he knew it was to face another week of struggle – to keep his company, his workers and production going. After 40 years as an oilman, he has seen his share of world recessions and oil price crises.

But what happened by the end of that day, April 20, was unprecedented. The price of US oil had turned negative for the first time in the country’s gluttonous history of crude production, from the wild Rockefeller days of Pennsylvania gushers to the recent controversial fracking boom in North Dakota.

James says companies like his are now beginning to shut production that no longer makes commercial sense, from the Deepwater Gulf of Mexico to North Dakota and everywhere in between. He says the negative pricing prompted his company to “address more reduction of capital investment, cut salaries, benefits and look at possible early retirements and layoffs – all things that we don’t want to do.”

“My hope is that I can keep my company viable and keep my employees working and their morale strong through this downturn. I pray that I can guide our organisation through the valley and live to fight another day.”

In practice, the negative price of US oil meant buyers got paid to take oil off sellers’ hands — as much as $37 a barrel. Just a week earlier, buyers paid $20 a barrel and if they wanted some in January, they would have spent $60 a barrel. So what went wrong?

While Monday’s prices were underpinned by technical trading factors, it was undeniable that something had gone very wrong in the American oil patch. In fact, many workers, whether offshore engineers or veteran executives like James, were well aware of the looming storm.

James heads one of the many independent oil and gas companies in the country, with a history going back several decades with oil and gas production both offshore and onshore, including in the shale patch. It was a revolution in shale that had spurned an energy renaissance in the country. Technological advances allowed the tight rock formations to be drilled horizontally, fractured and stimulated with chemicals to coax oil out.

Production became so prolific by 2015 that a four-decade ban on oil exports was lifted, opening the door to even more production for global markets. Output almost doubled between 2010 and 2015 and then jumped another 40 per cent to 12 million barrels per day (mbpd), or a tenth of global production, between 2016 and 2019, according to the US Energy Information Administration.

In some ways, it was a typical American success story about how free markets, entrepreneurship, technical innovation and boundless optimism can lead to unbridled riches. But that success story, it now turns out, has a sting in its tail.

The fact is, the US oil boom sparked a proliferation of companies that chased down every acre of land sitting over shale, borrowed millions of dollars from Wall Street and promised soaring production rates that, really, were technically difficult and not always geologically wise to produce.

Millions of acres of land in the Permian basin in Texas, the Bakken in North Dakota and others were put under factory-like production, attracting huge amount of heavy traffic carrying equipment and chemicals as well as the flaring of the gas that is often found with oil, due to a lack of infrastructure to process it separately.

The oil production frenzy also had wide-reaching implications abroad – mainly by threatening Saudi Arabian and Russian dominance in global oil.

The US shale revolution halted a two decade drop in oil production and muscled American crude into the global market. To protect their own oil industries and petrodollars, Russia and Saudi Arabia entered an uneasy agreement, dubbed OPEC+, to restrict global oil supplies and so prop up prices. This collaboration continued from 2016 to this year, even though Moscow and Riyadh’s relations were strained at the best of times and both knew that higher prices, while providing relief for their oil-dependent budgets, also kept the shale producers in business.

But the Covid-19 pandemic swept away this precarious status quo. With flights grounded, industry halted and cars off the road in country after country, oil consumption plummeted. Experts warned a whole third of global oil demand had disappeared, dwarfing OPEC’s previous oil supply cuts which amounted to about two to three per cent of demand. It was against this backdrop, over a March weekend, that Russia and Saudi Arabia fell out over the supply cut deal, prompting Saudi Arabia to cut its prices and flood the global market with its oil.

“The Saudis said, ‘forget it, we’ll go after market share’, so that was that,” says Ernie Barsamian, founder of The Tank Tiger, a New Jersey-based company that acts as a clearing house for oil storage. “I have never seen it happen so quickly but that March 7 announcement (by Saudi Arabia) sent oil to a contango structure and by March 8, I was getting phone calls to secure all the storage I could,” he says. Barsamian was referring to a pricing structure in the market which makes it more profitable to store oil for future sale because current prices would be lower relative to future prices.

Oil insiders knew that current prices would be much lower because Saudi Arabia’s mammoth oil production had been choked back for years by the OPEC cuts. Opening the spigot on the world’s cheapest and easiest to access oil, as Riyadh indicated it would do in March, would have devastating consequences. And they twigged that, whether as a favourable trading strategy or just to protect profits, leasing storage space for oil was key in the coming weeks. So that is why Barsamian’s phone was ringing off the hook that day and continued to do so for another two weeks until all the storage ran out. That included leasing and subleasing tanks in Cushing, a small town in Oklahoma, which is the physical delivery point stipulated in US oil futures contracts.

Thousands of kilometres away from the East Coast, Neil (not his real name), a senior manager at a mid-sized oil independent in the North Sea, was also keenly feeling the impact of the global crisis and in more ways than one. While Saudi was ramping up production, he was recovering from Covid-19. “There is a lot of fear and uncertainty,” Neil explains, now fit and healthy, via Zoom.

“At the operated assets that are on the wire, that are very marginal in terms of profitability, the fear is much more prevalent and there is trepidation as to what happens next. And those people are working even harder for their survival; some of them know the writing is on the wall.”

The oil sector, especially in the West, where it is subject to free market rules, knows what it needs to do to adapt: slash costs and hold back on new production to ride the storm out while the market rebalances. The problem is the scale of the problem; the destruction of demand by Covid-19 is unprecedented compared to the oil boom and bust cycles of the 1980s, early 1990s and since 2014.

Like many oil companies operating in the North Sea, Neil’s is looking at whether to bring forward the decommissioning of some oil fields that have been producing for years. Like James’ company in the US, Neil’s is not too indebted: “We could probably survive a year or two with the losses that we’re predicting.”

But that is not the case with many other oil outfits, which analysts expect to either put some of their assets for sale, restructure their debts or even go bust, prompting a massive consolidation of the industry.

If oil executives, analysts and even political leaders knew the terrible state of the market in March, how did the chaos on Monday come as such a big surprise? “On Monday, things got crazy again,” Barsamian recalls. “A lot of people participating in the futures contracts were surprised they couldn’t liquidate their long positions – they were scrambling for alternatives rather than giving oil away. I kinda felt bad for them; I couldn’t do much but educate them.”

Many rushed to sell their contracts when they realised they could not cancel their bet on oil prices rising, roll over the contract or take physical delivery of the oil. They could not rely on the oil storage normally listed on sites like Barsamian’s, like him, everyone was busy offloading back in March.

Even doctors and dentists were calling Barsamian, asking somewhat innocently where they could get storage from as they heard it might be a good investment. “I had to educate them too,” he says.

There are usually balancing mechanisms that prevent this kind of thing from happening, says John Coleman, principal North America oil analyst at Wood Mackenzie.

The main relief valve is letting oil out of Cushing into refineries, thereby emptying storage for more oil. But the destruction of demand for oil products such as gasoline for cars and jet fuel for planes meant refineries were full and no one in their right minds would let go of storage in Cushing.

“The combination of additional pressure of trying to roll over contracts, not having the backstop of physical storage to accept deliveries and the gridlock that was created from the lack of demand elsewhere to move barrels out of Cushing really created this perfect storm where calamity ensured and prices went negative,” says Coleman.

Since that calamity, US benchmark oil prices, the West Texas Intermediate (WTI) contract for June delivery, traded at $16 a barrel while global benchmark Brent contract traded at $21 a barrel.

Nevertheless, the fallout of Covid-19 continues with oil demand remaining extremely low, storage leased for months and oil companies only reluctantly dropping their production. Few analysts would entirely rule out a return to negative prices, although Coleman allows himself a glimmer of hope.

“We’re going to see 30 days of extreme price pressure on US producers, more responses such as shutting in of wells, removing product from the market and reducing physical pressure into Cushing,” Coleman said. “It’s not to say that fundamentally there will be a material improvement. But – perhaps?”

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