Giving away oil

Tuesday oil producers had to pay other parties to take their oil off their hands.  Well, not exactly.  What did happen is the price for May delivery of West Texas crude fell to -$38 per barrel.

So what gives?  Keep in mind these are futures contracts that are used for risk management; these are options to sell.  Oil companies purchase these futures to hedge against the risk of price drops.  For instance if the price of oil today was $30 per barrel and you were worried about the price dropping below $25, you might want to buy an option that lets you sell at a price of $28.  Most options are never exercised; they either expire or are traded.

On Tuesday there were not any buyers for May delivery at prices above zero.  This is happening because (1) global demand for oil has collapsed as people shelter at home to avoid COVID-19, (2) major producers such as Russia and Saudi Arabia have yet to cut back on production despite the demand situation, (3) it is costly to shut down a well so many producers have procrastinated, and (4) we are about to run out of storage space.

In a nutshell, a simple supply and demand story.  Looking ahead, expect prices at the pump to drop in the coming weeks, perhaps falling below $1 per gallon.  For more insight, see this video clip of my interview with local news channel WRAL.

Energy independence, here we come!

Good news in today's NYT lead story: the US is actually becoming more energy independent.  In 2011 we imported 45% of our liquid fuels, down from 60% six years later.  The reasons are economics 101: more supply and less demand.  Production is up because of technological advances and incentives created by higher prices (drill, baby, drill).  Demand is off because of the recession and, yes, incentives created by higher prices (drive less, buy a more energy efficient vehicle, move closer to work).  

No, we really are not running out of oil

So says expert Daniel Yergin in this weekend's WSJ.  The key point (especially relevant to this week's discussion of cost in MBA 505) is that the price of oil drives incentives for discovery and recovery.  We may be out of $25/barrel oil, but as technologies for exploration and extraction develop AND as higher prices make some oil fields economically viable (that would not have been viable at lower prices), the market provides the incentives to find the juice we need to keep our SUVs rolling.  Yergin shows that the "sky is falling, we are running out of fossil fuels" claims go back as far as the 1880s, when production mostly took place in Pennsylvania and it was common knowledge that there was no oil west of the Mississippi River. 

Please note that I am not saying that we should sit back and let the price system solve all of our energy worries.  What I am saying is that the claims that we are facing some sort of energy shortage are economic nonsense.  As long as prices are allowed to adjust, the market will make sure that buyers and sellers in the petroleum market are able to work with each other. 

Don't blame speculators for oil price spike

Say my NC State colleagues Srini Krishnamurthy and Richard Warr in an N&O op-ed today.  Srini and Richard point out that the recent run-up in oil prices can easily be explained by rising global demand (blame China) and falling supply (blame Libya).  Also, futures markets themselves are subject to the same market forces -- for every speculator who wants to buy an option that pays off when oil prices rise, there has to be a seller who thinks otherwise.

By the way, I just bought gas this morning and the price has fallen in Cary to 3.71 per gallon.  Do speculators get credit for falling prices too?