The rout in crude oil markets continues, posing severe consequences for the Canadian energy sector. Crude oil, according to the West Texas Intermediate benchmark for delivery in Cushing, OK, plunged below US$7 before recovering to over US$13 by end of business—a drop of 36 percent from yesterday’s close. The Western Canada Select benchmark, which typically sells at a discount to WTI, traded around US$5 per barrel. The drop in oil prices reflects continued market concerns about rising oil inventories amid incredibly weak global demand.
Yesterday, I highlighted how the futures contracts on West Texas Intermediate (WTI) crude oil for delivery in May closed at a negative number of -US$37 per barrel—the first time ever to hit negative.
Today, I had many clients asking, how to make sense of such absurdity? To understand the negative pricing, it helps to understand how futures markets work. A futures contract entitles the owner to receive physical barrels at a pre-determined date and location (WTI delivery is in Cushing, OK). Investors that held the May-dated contracts were betting that demand would rebound, or supply decrease, boosting the price and enabling them to exit the contract with a profit. Most investors never intended to take receipt of the physical crude oil. But, demand remained weak while supply was hardly impacted.
In Cushing, where much WTI priced oil is stored in 15 terminals, inventories have risen 48 percent since February, making storage capacity dear. Given the exorbitant storage costs, investors had little choice but to pay to get rid of the contract. For those on the other side of the transaction who had spare storage capacity, huge profits were to be had, as they could take the oil and then sell it in futures contracts for delivery in June, which was still priced around US$20 yesterday.
Yesterday’s bizarre slump to negative price occurred because the contracts roll over from one month to the next near the 20th day of the month, and would have compelled owners to take physical delivery next month. This is what led to the panic exit from positions yesterday. In other words, it was a technical event caused by the expiration of the contracts. It did not reflect the true economic value of crude oil.
But, the selloff today is largely a non-technical event and the price is a signal of what the value of oil is amid the global recession caused by the pandemic. It highlights the continued imbalance of rising inventories and inadequate storage capacity despite the recently announced OPEC oil cut.
This adds to the strains in the Canadian energy sector that are already acute, which has significant implications for the Canadian economy.
In 2019, the Canadian oil and gas sector generated economic output of $110 billion, representing 5.6 percent of GDP. The sector also supports roughly 528,000 direct and indirect jobs in 2017. Moreover, the sale of its products generate significant revenues for governments. Indeed, the oil and gas sector contributed an average of $8 billion in revenues each year to provincial and federal coffers between 2016 and 2018.
Since 2015, many Canadian energy firms have cut operating costs in response to lower oil prices, leaving little room to cut further. Producers have reduced supply, but many firms still have to maintain production to cover costs and avoid costs of restarting if they were to shut down. Capital investment by the energy sector plummeted from a 28 percent share of Canadian investment in 2014 to half that share in 2018. This was opposite to the trend in the United States, where investments in oil and gas ballooned in response to shale oil development.
Our economic outlook assumes that the prevailing economic lockdown will be relaxed in Europe and North America this summer and global demand will improve in the second half of the year. This should stop the rout and help crude oil prices to regain some lost ground. Nevertheless, the price of oil will remain low. Indeed, our year-end target is roughly half where it was at the start of the year.
This outcome will dampen Canadian economic activity, cost well-paying jobs, and hurt government revenues at all levels. As mentioned yesterday, the fiscal and monetary stimulus announced so far will help the energy sector, but the situation for many firms will still be dire. Consequently, policymakers may need to consider something akin to the US TARP program used to support the financial system in 2008, but this time purchase or insure troubled assets in the Canadian energy sector.
