There is always an anomaly that appears during a crisis to disrupt markets or economies to an extreme, and the COVID-19 crisis is no exception. Rising production and collapsing demand, due to a deliberate policy of an economic shutdown, is causing an unprecedented glut in the oil market. This has sent oil prices for West Texas Intermediate (WTI) to a multi-year low, which reached negative at one point.
Travel restrictions, due to social distancing stay-at-home sanctions, have reduced the global demand for oil by an estimated 5.6 million barrels per day (mb/d). Research conducted by BP shows that almost 58% of global oil demand is derived from fuel for transportation. This makes the current situation much worse than a normal recession because of the widespread implementation of travel restrictions.
This problem has been brewing for a while, with Russia and Saudi Arabia unable to agree on production cuts in early March. This caused a bizarre situation in which Saudi Arabia actually increased production and sparked a price war. The main oil producers gathered around the table at Easter and agreed to an historic cut in production to contain the oil glut. Production will be cut by 9.7 mb/d starting on 1st May. Cuts will begin to taper each month to 5.6 mb/d by the end of the year.
Despite the historic significance of the agreement, the agreed cuts do not appear to be aggressive enough to balance the large drop in demand. Oil inventories are likely to continue to rise in the short term, with storage facilities at capacity; this is putting further pressure on oil prices.
The anomaly of negative oil prices happened this week, with the May contract for oil delivery, for WTI, falling as low as -$40 a barrel. The situation was created by holders of the oil contracts having to pay to have the oil taken away and stored. Global storage of oil is almost at capacity, which increases the prices to have the commodity stored. This price of storage exceeded the actual price of the oil itself, thereby creating a negative contract.
This volatility in oil prices has spilled over into other asset classes, with global equities feeling the pressure. It is likely that the distortions we are seeing in the oil market will contribute to volatility in other asset classes, in the short term. However, it is expected that this period of extreme dislocation will dissipate in the second half of the year, as travel restrictions are gradually relaxed. So, while oil could contribute to volatility in equities and fixed income over the coming months, we do not expect it to become a major driver.
