The Oil Price Crash in One Word: ‘Inelasticity’

(Bloomberg Businessweek) -- The historic crash in oil prices on Monday—to below zero, believe it or not—can be explained with one wonky word: “inelasticity.”.The demand for oil is inelastic. It doesn’t respond dramatically to changes in price in the short term. When we’re cooped up at home because of Covid-19, we’re not going to do a lot of driving no matter how cheap gasoline gets..The supply of oil is also inelastic in the short term. It’s expensive to shut down a producing well, so some producers are willing to keep pumping crude temporarily even at a loss..Saudi Arabia, Russia, and others are producing more oil than the market can consume, in a game of chicken—each hoping the others will back down. President Trump’s effort to broker a deal to cut production failed to stop the rout. In the long run, both supply and demand are more elastic, but as John Maynard Keynes said, in the long run we’re all dead..Storage is ordinarily the buffer that stabilizes inelastic markets. If supply exceeds demand, the excess goes into tanks. But the overproduction has gone on for so long that there’s almost no place left to store crude. “It’s kind of desperation time,” says energy economist Philip Verleger of PKVerleger LLC..Hence the crash. On Monday, the contract for May delivery of West Texas Intermediate crude fell more than $55 to settle at a negative $37.63 a barrel on Nymex. That was the first time in history the contract traded for less than zero. It was well below even the lows of March 1986 and December 1998. The last year that oil averaged less than $10 a barrel was … 1974. .“We’re living out the worst possible nightmare” for oil producers, says Steven Schorck, principal of the Schorck Group, an energy-market analysis company based in Villanova, Pa..Prices can go outright negative in inelastic markets: The sellers pay the buyers to take it. The natural gas that comes out of the ground as a byproduct of oil production sometimes costs less than zero because it’s viewed as waste. Power generators sometimes pay customers to use electricity because it’s cheaper than shutting down power plants and having to restart them later. Dairy farmers haven’t reached the point of paying people to buy their milk, but they’re dumping what they have because the cows are producing more than the market will bear. (You can’t shut off a cow.).It once seemed improbable that the price of oil would go to zero or turn negative, because it’s more easily storable than milk, electricity, or the gas associated with oil production. But as long ago as mid-March, Wyoming Asphalt Sour, a dense oil used mostly to produce paving bitumen, was bid at –19¢ a barrel, Bloomberg News reported..The reason for the sharply negative price is that speculators are desperate to get out of their contracts before expiration—because if they still own the contract when trading stops, they’ll be required to take delivery. And most of them have no way to do that. There are no oil tanks on Wall Street. As Bloomberg News wrote, “The tens of billions of dollars traded every day in WTI futures are almost always settled financially, but any contract that hasn’t been closed out after expiry has to be liquidated with a physical delivery of oil if the parties can’t come to some kind of over-the-counter agreement.”.Oil bulls say the steep decline in prices is a temporary phenomenon mainly affecting one particular contract, the one owned by Nymex for May delivery of WTI. They note that contracts for later delivery were substantially higher: $21 for June, $27 for July, and $30 for August..True, but there’s no guarantee that the prices for the later months will stay that high. Unless production falls sharply, or demand soars, there will be strong downward pressure. People won’t buy oil they can’t use immediately if they have no place to store it, no matter how low the price..Here’s Schorck again: “The fundamentals get even uglier in the June period. There’s no reason we can’t see June just as low as we’re seeing the May contract now.” He said that earlier in the day, when the May contract was a bit over $10. “All the doctors and dentists who have been speculating on oil to go up are getting killed.”.Betting on the inelastic oil market is a dangerous game. One factor supporting the price of oil has been purchases by the United States Oil Fund, an exchange-traded fund that owned about a quarter of the May contracts, according to Bloomberg News. The fund bought them on behalf of investors speculating on a rebound in the price of oil..The fund began selling May contracts well ahead of Tuesday’s expiration and replacing them with June and July contracts. That removed a key price support for the May contract. John Love, chief executive officer of United States Commodity Funds LLC, which manages the United States Oil Fund, wrote a piece for the company’s website this spring warning investors to be prepared for the days when prices go kerflooey—even though they happen rarely. “Some might consider an event that happens 0.25% of the time to be too improbable to worry about,” Love wrote. “However, ask yourself this: How well will you sleep tonight if you know that once every year or two someone is going to wake you up by dropping a tarantula on your face?” Read more: Trying to Make Sense of Markets? Here’s Econ 101 in Five Books.©2020 Bloomberg L.P.

The Oil Price Crash in One Word: ‘Inelasticity’

Oil demand doesn’t respond dramatically to changes in price in the short term, while it’s expensive to shut down a producing well

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The Oil Price Crash in One Word: ‘Inelasticity’

Oil demand doesn’t respond dramatically to changes in price in the short term, while it’s expensive to shut down a producing well

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