2020 is certainly a year for the record books. Just as the world seemed to be getting a grip on the Coronavirus situation, oil markets sprung a surprise.
For three days in April, oil markets took the spotlight off the Covid-19 pandemic. The West Texas Intermediary (WTI) crude oil futures did something unseen or unheard of, as the world gasped in awe.
Between late April 19th and the 21st, oil futures contracts fell to zero for the first time in history. Later the same day, WTI crude oil futures prices for May delivery collapsed further, falling to intraday lows of -$40.00 before settling at close to $10.00.
It would be difficult to overstate the effects of this phenomenon. As fuel prices impact just about every aspect of the economy, the oil market meltdown has a profound impact ranging from travel to the agriculture sector.
WTI Crude Oil Futures (CLK20), May Delivery Price Chart (Source: Barchart)
The price crash was unprecedented, at least in the commodity futures markets. For a brief moment in history, crude oil producers were paying consumers money to buy oil from them.
But how on earth did WTI crude oil prices turn negative?
No one would have imagined oil markets would come to this, just over a decade after an energy crisis was declared.
In hindsight of course, the writing on the wall was evident. A number of factors have been influencing oil prices over the past decade, leading to lower prices – from the global financial crisis of 2008, to the oil price wars in 2014, to the current pandemic.
More recently however, the slump in crude oil can be narrowed down to the following:
Supply and demand:
As the global economy stood still due to the pandemic, demand for crude oil fell sharply, but supply continued.
One could argue that OPEC+ pledged to cut oil production early in April. But this was effective from May onward, a tad too late. And turning off the pipes isn’t as simple as turning off the taps. So, oil continued to flow.
The Oil Futures Markets:
The front month WTI oil futures contracts in question were for May delivery. What this meant is that buyers could pay upfront, for delivery of crude oil in May. The May’ 20 futures contracts (CLK20), trading at the NYMEX (New York Mercantile Exchange) were due to expire on April 20th.
This meant that oil traders holding a long position in the contract to expiration would automatically get delivery of the underlying commodity. But with the world awash with crude oil and lack of storage, traders closed out their long positions, leading to flash selling in the May contracts for WTI.
Not enough storage for crude oil:
One futures contract in WTI crude oil comprises 1000 barrels. If you do the math, you will soon realize why storage concerns added to the meltdown. Oil tankers that transport crude oil started turning into floating storage spaces, leading to the price of renting crude oil tankers rising by over 100%, because oil storage companies are already at full capacity.
Crude oil storage is not as simple as storing the barrels in one’s garage. All things considered, the WTI futures markets reached a tipping point.
The chart below shows the oil market dynamics from a supply demand perspective. Global consumption of crude oil has been falling since the last quarter of 2019, but production cuts were coming in at a slower rate. Geopolitical factors are to blame.
EIA Global liquid fuel consumption/demand (Source: US. Energy Information Administration)
And if the forecasts are true, oil consumption is expected to hit a floor only during the second quarter of 2020, based on current data. But what does all this mean for the agricultural sector?
Are lower fuel costs good news for agriculture?
Within agriculture, the influence of oil markets varies depending on the product. Corn (a raw material for ethanol, used in gasoline), soy and wheat prices, for example, are strongly correlated to oil markets.
As can be seen from the chart below comparing Corn and WTI futures prices, lower oil prices are also dragging corn futures lower.
Historical comparison of Corn and WTI futures
Beyond grains, the effect of oil prices on agriculture depends largely on the inputs and logistical requirements of a given sector. Reduced logistical costs can be a huge boon for many agribusinesses, whose margins may depend largely on logistical efficiencies. Energy-intensive operations like harvesting and sowing may also become cheaper, leading to operational savings.
However, lower energy prices can be a mixed blessing. While there are advantages of lower oil prices, there are also some disadvantages.
Here are some of the major impacts:
- Lower oil prices will greatly reduce the feed costs and likely improve operating margins for livestock producers
- The cost of operating machinery and energy consumption will offer a discount for producers
- Shipping and transportation by land, sea or air will be cheaper due to lower fuel costs, taking a smaller than usual chunk from the supply chain
- But lower oil prices can be negative for crude oil net exporting countries. Lower revenues can lead to lower demand for food
- The US dollar has received a bump, thanks to the fundamental collapse in oil prices. But this automatically raises the cost of food imports, which are priced in US dollars
- Currencies of oil exporting countries tend to exhibit similar trends to the price action in oil. So, a weaker currency can raise import costs for such countries dramatically
The impact of oil on agriculture can be especially pronounced in emerging economies. For agribusinesses that export to the developed world, currency fluctuations can play a major role, since arbitrage opportunities tend to increase as local currencies weaken against less oil-dependant currencies such as the Euro.
Currency devaluations in net oil-exporting countries can also lower operational costs, but can also increase the relative cost of importing necessary inputs like fertilizer applications. Overall, the conventional wisdom holds true – agribusiness generally benefits from lower oil prices, outside of the grain and oilseed sectors.
What’s happening to the oil markets now?
While WTI oil futures turned negative, the June contracts (CLM20) are now the active contracts which are trading in the positive. Brent Crude Oil, the international benchmark for oil prices, is trading around $20 a barrel.
While there has been a significant decline, oil prices are still stable (and well above $0.00). This means that zero cost fossil fuels are still unrealistic.
But to curb the supply glut, there are a few ideas floating around as well.
- The U.S. is now one of the largest oil exporters (thanks to shale oil). There have been calls for imposing mandatory production cuts to curb the decline in oil prices
- There are talks that the U.S. could impose tariffs on oil imports which will create demand for domestically produced oil supplies. But this will come at a huge geo-political risk
- OPEC and Russia (OPEC+) could see bigger production cuts, possibly sooner than initially agreed
- President Trump is calling for bailout of the oil companies hit by the price crash amid this causing a controversy, given oil company’s influence in Washington
All said and done, it is true that crude oil (WTI) briefly crashed into negative territory. But in the aftermath, prices are back, adjusting to the new norm. While the news might grab the attention of the masses, it is vital not to get caught up in the hysteria.
There are no outright winners and losers due to the oil price crash. The global economy runs on fossil fuels for the moment and this requires a fine balance between supply and demand. However, the good news is that the equilibrium is often restored. Sometimes this can be quick, within a few quarters, but sometimes it can take years.
As can be seen by the WTI futures forwarding pricing curve, currently investors expect oil prices to trade around $50 a barrel eight years from now. Clearly, we are expected to have cheap oil for the immediate future.
WTI Crude Oil Futures, Forward pricing curve (Source: Barchart)
The economic impact of the Covid-19 pandemic is much larger than initially expected. There is a good chance that the economic recovery will take months, if not years. Nonetheless, the agriculture sector continues moving forward, driven by a non-negotiable global demand. While low oil prices are a mixed blessing for the ag sector, businesses that can mitigate the downsides stand to benefit significantly in terms of operational and logistical savings.
Read more from Farmfolio.