Oil prices: what brings them to negative values

US, WASHINGTON (ORDO NEWS) — In recent days, we have witnessed another renewal of long-term lows in futures for reference grades of oil. March 30, contracts for Brent crude oil fell below $ 22 per barrel. The last time such low prices were observed back in 2002. As for the contracts for WTI oil, they briefly sank below the psychologically important level of $ 20 per barrel.

This price is close to the full cost of producing liquid hydrocarbons in the Persian Gulf. It is believed that the cheapest oil in the world is produced in this region.

It should be noted that oil prices reached extremely low levels even before the expiration of the collapsed transaction to limit the level of black gold production in the OPEC + format. From a formal point of view, the agreement was valid until the end of March 2020. Thus, the collapse of oil quotes was largely due only to the expectations of a medium-term increase in production by countries such as Russia and Saudi Arabia.

At the same time, one should not underestimate the scale of the real reduction in global physical demand for oil in connection with the coronavirus pandemic. According to the assessment of the Deputy Minister of Energy of the Russian Federation Pavel Sorokin, at the moment its drop is about 15-20 million barrels per day. For comparison: during 2019, it amounted to just over 100 million barrels per day. Thus, global oil consumption fell by almost 15–20%.

The right decision of Russia

Based on these data, it becomes obvious that Russia’s widely criticized decision to withdraw from the OPEC + oil transaction was correct and very timely. The collapsed transaction assumed a total reduction in production by its participants by 1.7 million barrels per day compared to the level of October 2018. An additional voluntary reduction in production by Saudi Arabia by 400 thousand barrels per day served as a weighty addition to the agreed volume. However, even a more radical decrease in the total quota would not be able to balance supply and demand in the current conditions.

Moreover, the current decline in global demand is comparable to the total oil production by Russia and Saudi Arabia. By mid-March, it amounted to about 21 million barrels per day. Thus, to maintain oil quotes at $ 50 per barrel, two countries would need to completely stop oil production. For obvious reasons, such a scenario is impossible even in current realities. In such a situation, it is better for Russia to be unbound and have freedom of maneuver.

By the way, in the current conditions, the painful weakening of the ruble exchange rate is equally inevitable. In times of sharp decline in global production, the position of commodity currencies cannot remain unshakable. The Russian ruble is no exception in this regard. Recall that in the second half of 2019, the total share of oil, oil products and natural gas amounted to 57.2% in the structure of Russian exports in value terms.

At the same time, gas export prices are directly or indirectly tied to oil quotes. Therefore, the government and the Central Bank can only mitigate the pace of the negative medium-term trend towards a drop in the ruble exchange rate.

We repeat that by the end of March 2020, exchange-traded oil prices were already approaching the level of the total cost of production in the Middle East. Oil production in this region is one of the cheapest in the world for a number of objective reasons. At the same time, representatives of the oil industry, working in the North Sea and in the legendary North American oil state of Texas, have already seriously talked about the impending decline in production volumes and a reduction in investment in the development of new fields.

According to first conservative estimates, UK oil companies will reduce capital investment in aging fields by one third. As we can see, the process of reducing the production of black gold due to projects with a relatively high prime cost is already starting to gain momentum.

The real cost of oil

By the way, the issue of the full cost of production in different regions of the world is not as simple as it seemed at first glance. First of all, this indicator may differ significantly for nearby prospective, young and old deposits. Large hard-to-recover reserves of many companies seem to be unprofitable for commercial mining. At the same time, mining enterprises often perceive the real cost of production as a trade secret, which should not be disclosed.

In addition, loud statements by industry participants about the low cost of production starting from $ 2-3 per barrel usually involve the so-called lifting cost, or the cost of lifting oil from a well in an already developed field. It is no secret that a good resource base and ready-made infrastructure were largely inherited by Russian companies from the powerful oil industry of the USSR.

At the same time, cheap oil from Western Siberia must be delivered at least to the main oil pipeline, railway or sea port. The specified mathematics is even more complicated if the oil company has large loans, including in foreign currency. Again, many transaction costs for a variety of reasons are significantly lower for offshore oil supplies from the Middle East.

To understand the real cost of oil in Russia, it is worthwhile to rely on a recent assessment by RF Deputy Minister of Energy Pavel Sorokin, which involves an average cost of $ 25 per barrel. But, according to him, Rosneft needs a price of $ 35 and higher due to its heavy debt load. According to a recent alternative estimate by the Saudi oil company Saudi Aramco, the average cost of Russian oil is a little over $ 40 per barrel. And Russian offshore oil costs another $ 2-3 more.

As for Saudi Aramco’s own production costs, it is estimated at slightly less than $ 20 per barrel. The cost of oil production in neighboring countries is approximately the same.

An additional degree of complexity in the process of pricing in the oil market is introduced by the fact that a large number of different types of oil are produced in the world, which differ significantly in composition from the reference brands Brent and WTI. Concrete refineries are “ground” for certain types of oil and cannot work with others. That is why the United States is both an importer and exporter of oil of various characteristics.

Negative oil prices

For the same reason, a paradoxical situation of negative oil prices in the United States became possible. At the end of March 2020, North American producers of low-quality sulphurous oil began to pay for the exemption of oil from their own storage facilities. So far, this practice is more profitable than the extremely undesirable conservation of existing wells. By the way, the physical deliveries of several cheap varieties of North American oil are already going at prices ranging from $ 3 to $ 12 per barrel.

It is worth mentioning the growing deficit of free oil storage facilities on a global scale. As usual, during periods of low hydrocarbon prices, oil tankers begin to be used as floating tanks. In mid-March, the freight cost of the respective vessels increased by almost 10 times. And the owners of oil pipelines in the United States began to demand from their customers evidence of a buyer for the pumped oil or the possibility of its shipment after completion of transportation. At the current ratio of production and consumption, all world storage facilities will be completely filled with oil within two to three months.

US Position

Having examined the main economic aspects of the current situation on the world oil market, one cannot ignore the equally important political and geopolitical issues. In this regard, the US position can play a very significant role. President Trump has already hastened to congratulate his compatriots on falling gas prices. But let’s not forget that the United States has approached the current oil crisis, acting as the world leader in black gold production.

The accumulated financial problems of the North American shale oil sector are not a big secret either.

In other words, the United States is objectively interested not in low but in “average” hydrocarbon prices. That is why Washington did not actually impede the sufficiently long existence of the OPEC + oil transaction. Following this logic, some actions on the part of the United States can be expected to restore oil prices. The first few steps in this direction have already been taken.

First of all, the US president has already stated that he intends to “at the right” time to intervene in the “devastating” price war of Russia and Saudi Arabia. In addition, he took the initiative to purchase large volumes of oil at a good price in order to completely fill strategic storage facilities. The physical volume of such a purchase was estimated at 92 million barrels. However, later the US Department of Energy canceled the relevant tender.

It is worth paying attention to the accusation of Venezuelan President Nicolas Maduro and a number of his associates of involvement in the international drug trade. This country has long been under American sanctions. Apparently, such a loud and serious accusation was held up to the right moment.

Meanwhile, Venezuela remains the world leader in proven oil reserves. Against the backdrop of these events, the Russian company Rosneft announced the cessation of work in Venezuela and the sale of assets related to activities in this country. Now Rosneft is counting on lifting targeted sanctions from two subsidiary sales legal entities.

The last plot gives us some hint at a possible further course of events on the world oil market. In the new realities in the coming weeks and months, it is likely that aggravation of geopolitical risks in the Middle East. One of the scenarios could be the overlapping of the Strait of Hormuz adjacent to the Iranian border under one pretext or another. About one fifth of the world’s oil consumed passes through this geographical point. This is comparable to the current surplus of liquid hydrocarbons in the world market.

If we ignore the current serious shocks, the oil market is in decline not the first or last time in its history. It is hardly worth seriously counting on the fact that we will no longer see oil at the price of $ 50 per barrel, or even much more. Once again, this is only a matter of time. In the worst case, it will take many months. It should not be ruled out that the oil quotations will quickly rebound upward within a few weeks amid new geopolitical threats. Most likely, we will observe something in between.

It is likely that oil prices of both key grades will return to a significant level of $ 50 per barrel by the end of 2020, as the current coronavirus panic subsides and the sharp decline in global industrial production is overcome.

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The article is written and prepared by our foreign editors from different countries around the world – material edited and published by Ordo News staff in our US newsroom press.