March 30, 2020 [Seeking Alpha – Published on March 25, 2020] – As investors reach their point of maximum panic, new articles are published about bearish oil price scenarios daily. One of the ones that caught my eye was a discussion about potential negative oil prices.
The logic was something around the terms that COVID-19 would cause a massive decline in demand, production couldn’t decline fast enough, worldwide storage would get overwhelmed, oil prices would drop to $0.
Interestingly enough, the same articles circled around in 2015, and analyst concerns that the worst isn’t over have made it onto Seeking Alpha recently. However, as we’ll see throughout this article, in our tour of crude storage capability, this is simply irrational bearish thinking.
Oil Storage Economics
Before we delve into this article, it’s important for investors to understand the economics behind oil storage. Many retail investors are probably asking why so much crude oil is going to be moved into storage all of a sudden.
The simple answer is break-even prices. The above graph shows what’s called the “Global liquid supply cost curve”, or in simpler terms the cost of production of every barrel of oil produced in the global supply, approximately. Something that should become immediately very clear is that at less than $60/barrel Brent, let alone the $30/barrel Brent, the majority of oil production globally is unsustainable.
That’s something that’s very clear to traders. As a result, they expect the fundamental economics of supply and demand will quickly balance this out. That is, they expect production to decline from declining capital spending, not instantly, but 20-30% for U.S. production in 2020 alone. Then, they expect prices to rapidly start to recover, just like they did after early-2016, doubling in <1 year.
So how do traders profit off of this? They store crude oil. At Cushings, the largest storage hub in the United States, the going rate for storing crude oil peaks at almost $0.50/month/barrel. That means, if prices recover by $10/barrel in a year, you’re making $4/barrel, or a 15% annualized profit at current prices. Not a bad deal at all. Although, if there’s no demand, production continues, and everyone’s storing the oil, that storage starts to run out.
As it does, oil prices go lower. Why buy the oil if you can’t store it?
COVID-19 Demand Decline
The fundamental premise of these analysts’ theory is that COVID-19 will cause a rapid decline in demand. That oil will need to be stored somewhere, as it continues to be produced, but the demand isn’t there. As the world runs out of storage, prices for that oil will decrease, until they hit $0. Some even think they’ll go negative. So the question then becomes – how much demand will COVID-19 decrease.
Thankfully, the kind folks at Goldman Sachs have already determined this for us. Mapping out shelter-in-place orders across the world, and the resumption of work, they forecast a peak of 8 million barrels/day in demand drop by the end of March with an average 7 million barrel/day drop as the highest monthly average drop, also for the month of March.
January and February are already over, but we’re going to assume a worst case scenario in this analysis and assume that 8 million barrels/day of demand will be removed from the market from March – June. At that point, we assume the virus will either reach global penetration (California expects 56% of people will get the virus in 8 weeks), or it will have a treatment. Either way it won’t decrease oil demand.
For 4 months, an 8 million barrel/day drop in demand represents a mind boggling 960 million barrels of oil that will need to be stored somewhere.
Global Country Strategic Petroleum Reserves
So where will this oil go. Where there’s two places. They can go to country strategic petroleum reserves or corporate strategic petroleum reserves. The United States, for example, has some of the largest strategic petroleum reserves in the world. Capacity here is an astounding 727 million barrels of oil and at last measure there were 635 million barrels of oil.
That represents roughly 92 million barrels in spare capacity. Now the US can’t handle 8 million barrels/day, but it can definitely handle 750 thousand barrels a day for the 4 month period. Globally, we don’t know how filled up all other country’s reserves are but given 1.4 billion barrels in total country reserves worldwide, assuming the same “filled up rate”, this could indicate almost 200 million barrels of spare capacity in the system.
And for those who think the U.S. is abnormal in this regard, countries across the world, especially net oil importers, are taking advantage of the decline to hold reserves. Not only is India, a net oil importer, has already placed bids for government permission to purchase 22 million barrels for storage that already exists. Simultaneously, the country has started work on facilities to store another 45 million barrels of oil.
Across the industry, which country storage reserves, the same picture is repeating itself. Given that many countries are probably like India, with more spare capacity (39 million barrels stored out of 61 million barrels in capacity), if we assume that’s true for the other 700 million barrels, that implies closer to 350 million barrels of total storage capacity until all country’s 1.4 billion barrels are filled up. That’s 36% of our estimated global supply gut.
Global Corporate Strategic Petroleum Reserves
As much room as there is in country storage capacity, there’s even more room in global storage capacity.
Starting with floating storage capacity, the number is actually much harder and complicated to put a finger on. Not all VLCCs are public, and not all grades of crude can be stored at sea. However, where there’s a will there’s a way, and companies will find ways to fill up all the ships they can if needed. The number of ships vary, but current estimates are that 30-40 VLCCs could be removed for storage in the coming weeks from the market.
Iran alone has 40+ VLCCs, and various publicly traded companies, like Frontline Ltd. have >20 VLCCs. VLCCs can hold 2-3 million barrels of oil each, and there’s plenty of other carrier ships that can hold hundreds of thousands of barrels, if not more. Simultaneously, there’s 180 FPSOs and 100 FSOs in operation worldwide, each also capable of carrying 1+ million barrels.
Many of these FPSOs are owned by giants, like ExxonMobil’s Liza field, where as prices collapse, it makes sense to hold as many days of production on the FPSO as possible before sending it to shore. Conservatively, assuming 50 total VLCCs for storage over 4 months and half the FPSOs and FSOs at 500 thousand and 250 thousand barrels of storage each, and we get a net total of ~200 million barrels of floating storage.
Commercial crude storage is also difficult to place a finger on onshore. The U.S., for example, has 600 million barrels of commercial storage of which 450 million barrels are used. That’s net 150 million barrels. Saudi Arabia, which produces half as much oil as the US, has ~75 million barrels stored and a similar amount in capacity. Since the ratio is about the same, that would imply globally ~750 million barrels in corporate storage capacity.
However, it’s worth noting there’s also significant storage capacity for refined products (the U.S. has twice as much capacity for refined products as regular oil).
Production Decline Pace
Throughout all of this, we’re assuming no production declines, even as analysts say prices could go negative. As we discussed above, U.S. crude oil could decline by 2-3 million barrels/day in 2020 alone. As capital spending dries up, that could result in a 1 million barrel/day in decline for U.S. crude production in the next 4 months, a significant decrease.
Averaging that out, over the 4 months, that would result in 60 million barrels removed from supply alone (in our 960 million barrel/day surplus estimate).
At the same time, not only can spare production be turned off, like the glut of oil from Saudi Arabia (remember thanks to the bombings in late-2019 Saudi Arabia dropped/shut-off 4 million barrels/day of production in 1 day). Globally oil fields decline at 4.5%/year too – meaning in this 4 month period, roughly 2 million barrels/day in production decline assuming no effort into shutoff.
At negative oil prices, you can bet effort will be put into shutoff.
But that still means another 120 million barrels of oil naturally decreasing. Together, assuming no effort is put into shutoff, that would result in our worst case glut from 960 million barrels to closer to 750 million barrels. Given our result, as we’ll see below, shows 960 million barrels is easily manageable, 750 million barrels is much more manageable. This is an important analysis.
Our net result for commercial + country storage capacity worldwide comes out to 1.3 billion barrels of crude oil. That doesn’t include any new construction, but with a worst case expected surplus of 960 million barrels/day, that shows how there’s significant room for new storage. In fact, even assuming our worst case surplus of 960 million barrels/day (roughly double of the reasonable COVID-19 expectation) that’s ~70% of the world’s commercial + country storage capacity.
Additionally, this doesn’t discuss the potential for refined product storage. In the United States, there’s twice as much room refined product storage as there is for non-refined product storage. Refining should continue, especially as there’s massive demand for it and low crude prices, which should support significant storage here. The result here is that fears about a lack of storage capacity are unfounded.
It also doesn’t include any production declines over the next 4 months.
At the time of maximum bearishness is when commodities and oil can become a good investment. Investors forecasting negative sales prices for oil can’t see it get any more bearish than that. Investors are worried that OPEC+ along with COVID-19 can cause a maximum oversupply of oil that overwhelms storage capacity. However, as seen throughout this article, those fears are unfounded.
Worldwide there’s significant spare room for capacity. Assuming fields decline at their normal rate, and estimating a worst case impact for COVID-19, we’re looking at 750 million barrels/day of oversupply. That’s more than manageable by our estimated worldwide 1.3 billion barrels of storage capacity. That room means that as traders attempt to take advantage of an upcoming rise, oil prices won’t collapse as low as some analysts are forecasting.
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