I was wrong

For 18 months, there have been a lot of people lining up to serve me crow and hear me utter three words: “I was wrong.” I admit it. I was wrong. Oil did not trade at $0/bbl…. it closed at -$37.63/bbl. I’m sorry. Now, to the topic everyone is tuning in for: the reality of supply-demand in the pork industry.

It’s a little known fact that 70% of the bacon consumed in the U.S. is consumed in restaurants and food service establishments. Pigs grow from 2 lbs to 280 lbs in 6 months and past 280 lbs, they get hard to process. Less bacon consumption means that pork farmers have to consider euthanizing the pigs because they cost too much to feed, and can’t be processed. What? That’s not what you wanted to read about? How about milk?

With the coronavirus, milk demand is down approximately 12-15% across the United States. The average American in 2012 drank nearly 199 pounds of milk in a year, which means almost 30 pounds of demand is gone. Farmers have two choices: lower prices to encourage demand to rise back to the 199 (let’s be honest, we don’t need milk to get through the days, we need booze) or lower supply. As a result, they are dumping the milk the cows make because as one astute farmer said: “Cows don’t have no dimmer switch like that Fauci said…” (ok, I said that, but you get my point). And, that leads me to what you did want to read about…. oil prices.

Over the past few months when we have talked about ‘hedges’, I have pointed out there is a broad gap between the financial derivative instrument and the physical barrel and yesterday, we saw it in practice. Yesterday illustrated this point clearly. 100,000 contracts traded. That means 100 mmbo for the month of May (could be the same barrel trading 154 million times) traded paper yesterday, which is ~3.5 mmbo/d. That’s 40% of the oil the U.S produces per day. Was all that oil actually being sold for May yesterday? No. But like milk and pork, they are linked to the physical market. Here is the simplest way that I can explain it.

A ‘contract’ of 1,000 barrels is made when a producer says to their marketer: “I have 1,000 bbls to deliver in May.’ The marketer goes and sells those barrels to a refinery or other end user and thus, creates a market. But, like all things in a capitalist world, there are speculators and traders that want to intervene and participate in the market. They don’t want the physical barrels but they want to buy and sell paper barrels to capture value where they see a disconnect. April 21st (today) is the last day you can buy and sell the paper form of barrels. After today, if you are left holding the contract, you are going to get 1,000 barrels delivered. Like you, I don’t have a place to store 1,000 barrels of oil. So far, so good?

What happened yesterday (and no doubt will happen again today) is that the buyers for physical barrels are gone. Like milk and pork, the consumers are gone. The U.S makes 12.3 mmbo/d (shut ins and declines of at least 700 mbo/d have happened since the end of March) and with limited travel, we probably consume 6 mmbo/d right now (those barrels are converted in a refinery to gasoline, diesel, jet fuel, etc. etc.) and so no one needs to take 1,000 barrels more.

Yesterday, the holders of paper contracts that didn’t want to store oil in their swimming pool dumped those contracts and with no buyers the price fell, and fell, and fell and fell and ultimately bottomed out in the negatives, which literally means “I will pay you to take the barrels away from me.” A financial player got caught in a bad trade, and had to sell and sell and sell until they got out of it. Someone lost (and made) a lot of money.

In practice, producers aren’t selling their barrels in the spot market on the second last day of trading. The Argus roll, the price by which most oil contracts are settled is 2/3 of the first month close and 1/3 of the second months close, and they use the 21 trading days closing price (average) to calculate what that price is. So… as 1 out of 21 trading days…. yesterday’s close has some effect, but more like 5% of the total price and so for all practical purposes, yesterday didn’t impact the producers.

What does it mean for June? Well, if you look at June’s contract, it’s still trading in the $20s. Not good, but not negative. A warning shot was fired to all the physical sellers of barrels that at the end of a month, there is no one left to buy the barrels because no one needs them because no one is consuming oil. That should (and will) put pressure on June prices and message the market to shut in. Unlike pigs and milk, we can’t pour oil down the drain and euthanizing management teams, while the humane thing to do, won’t remove their barrels from the market.

The world produces 100 mmbo/d. The world is consuming AT MOST 65 mmbo/d right now until travel and the economy resumes. There is nowhere to store the oil so while your balance sheet may be hedged by the paper financial derivative, no amount of paper can save an industry from drowning in physical barrels.

Therefore, price will fall to the level that producers say “should I sell a barrel for cash flow, or leave it in the ground?” Ultimately, more and more companies are choosing to leave it in the ground and the longer it takes to shut wells in and the economy to restart, the lower prices will go to enforce that behavior.