Since the beginning of the pandemic, oil prices have collapsed. On Monday, April 20, the deliverable barrel for May traded at a historic low of minus $37.63. On that day, black gold was worth no more than the bulky stuff we want to get rid of in our garages. Harold Hotelling, who theorized the evolution of the price of oil in 1931, must have been turning over in his grave. If this dizzying fall is not compatible with Hotelling's model, a recent extension of this theory could reconcile it with the facts. And tell us something about oil price post-lockdown.
Negative prices and storage
Negative prices are not only for bads such as waste or pollution. We can also pay to get rid of goods such as energy. In a previous post, we explained how the non-storability of electricity could justify trading at a negative price over a short period of time. The drop in consumption that goes with the pandemic is conducive to this type of episode, as was the case on Easter Monday in Germany (-70 euros per MWh), Belgium (-91€) and France (-14€). While electricity supply and demand must be matched at any time, this is not the case for fossil fuels (oil, natural gas, coal), which can be stored and withdrawn from storage. It is the possibility of storing oil in a small volume that makes us prefer this source of energy to fuel our cars and planes. However, storing oil on a large scale requires infrastructure such as dedicated tanks or underground facilities, or pipelines, which are in limited quantities. As oil supply did not adjust to the dramatic drop in demand due to the coronavirus outbreak, oil has been accumulating in storage facilities. It seems that it is the saturation of this infrastructure in the United States that has caused the price per barrel to plunge into negative territory. Holders of barrels deliverable in May no longer have any use for them and, fearing that they will not be able to store them (or at a prohibitive cost), have preferred to dispose of them by paying buyers. A somewhat brusque reaction for traders who should have anticipated this risk before it came to this point. A loss for the companies taking such positions on the futures market which are already in troubles (airlines for example).
Storing oil underground rather than on the surface
How best to manage exhaustible natural resources such as oil? Economist Harold Hotelling answered this question in an article published in 1931. Hotelling described an oil field as a financial asset that is valued through extraction and sale over time. The rate of extraction depends on its return, i.e., the market price of oil. When the price is high, more oil should be extracted and sold. If the price drops, it is better to leave the oil underground and wait for happier days. The oil field is therefore a stock of resources that is being withdrawn at a rate that depends on its market price.
Hotelling's theory, although very attractive intellectually, does not match with data when it comes to oil. Producers should be expected to turn off the tap during this period of low prices while waiting for the post-coronavirus period to resume. The fact is that oil supply is not as responsive to price changes as Hotelling assumed.
Hotelling under pressure
A recent article revisits Hotelling's theory by considering the geological constraints of oil exploitation. The authors start from the observation that the rate of extraction depends on the pressure that oil exerts underground. It decreases as the oil field is exhausted, which reduces the quantity extracted. This physical property translates into an increasing extraction capacity with the amount of oil available underground. The company operating the oil field has little control over extraction once drilling is completed. The strategic decision is therefore not the rate of extraction but rather the rate of drilling. Using data from Texas, the authors show that it is the drilling of new wells not oil extraction that varies with the price of oil. Drilling increases when the price per barrel rises and decreases when the price per barrel falls. This results in a delay in the adjustment of oil supply to price: it is only when new drilling is fully active that more oil can be supplied to the market. The price fall is therefore delayed.
Lessons to learn
What can we deduce about oil during and after the coronavirus outbreak? First, oil price rises will be amplified during the economic rebound that is expected after the crisis. Indeed, the fall in prices has caused the least profitable shale oil and tar sand deposits to be shut down provisionary or permanently. When economic activity resumes, after drawing on surface oil stocks, drilling will resume. However, it will take some time before these new deposits have a significant impact on supply. In other words, we can expect a price increase amplified by limited extraction capacity if the economic recovery is rapid.
Secondly, even if the observed price decline is unprecedented in terms of its speed and scale, oil companies are used to adjusting their activity to the variation of oil price. They have done so in the past, reaping profits during economic booms and reducing their investments in exploration and development during bad times. The oil industry is made up of large groups with strong financial capacity to diversify the risks they face. Therefore, they should not be in the top priority of public spending dedicated to support the economy. The billions of dollars in aid spent by governments on oil-related industries do not provide the right incentives for responsible management. The $1.72 billion in subsidies to clean up orphan and inactive oil and gas wells should not be paid by Canadian taxpayers. The polluter should pay, not the polluted.
Since the fight against global warming requires a transition towards decarbonated energies, oil and gas companies must diversify their activities away from fossil fuels. Some have already done so by investing in renewable energies, energy services and research on energy conversion (power-to-gas, batteries). For them to be rewarded, public aid must be well-targeted towards technologies that are in line with the transition to a low-carbon economy. The public policies that will be implemented after the outbreak must take advantage of the opportunity to bring the economy into line with what seems to be, for the time being at least, the aspirations of the population.