What’s going on with crude? An internal Stillwater conversation in real-time as oil prices plummeted
April 21, 2020
By Kendra Seymour
As editor of Stillwater’s LCFS Newsletter and a contributor on many of Stillwater’s LCFS-related client projects, I spend most of my time working in renewables markets. Yesterday, as crude markets began showing particularly rare volatility, however, I caught up with my colleague Barry Schaps via Slack to get a better understanding of what was going on. Barry taught refinery and commercial classes at Shell for non-traders before he joined Stillwater, so I knew he’d be able to answer my questions. He kindly gave me a “refining 3-2-1 crack spread tutorial” and “crude trading 101” lesson alongside real-time market highlights as U.S. crude prices dropped off a cliff. Our conversation has been edited for clarity and length.
Slack conversation morning of Monday, April 20, 2020
Kendra: So, Barry, yesterday May WTI crude futures hit $14.50, which seemed pretty bleak, but early this morning they dropped to $11. You’ve been in this industry for a while. Just how bad is this??
Barry: This is the first time I have ever seen the calendar spread larger than the crack spread.
Kendra: Let’s pretend for a minute that I’m not an oil markets expert 😉 … Can you explain to me what a calendar spread and crack spread are?
Barry: Sure. A calendar spread is the difference in price between futures contracts that are trading for delivery in different months. For example, hypothetically, if the price for June 2020 crude was $25 and the price for July 2020 crude was $30 then the calendar spread would be $5. Some traders look even further out and execute calendar spreads between futures for December 2020 and December 2021.
The crack spread gets a bit more complicated, and it is used to estimate the profitability of a typical refinery. Let’s peer in our crystal ball for the following August 2020 prices: Crude oil $22/bbl, Gasoline (RBOB) $0.65/gallon and Diesel (ULSD) $0.90/gallon. One form of crack spread is represented as 3-2-1, which estimates the refinery margin of consuming three barrels of crude and producing two barrels of gasoline and one barrel of diesel. The simple calculation can be expressed as (value of gasoline produced) + (value of diesel produced) – (cost of crude needed to produce those gallons of gasoline and diesel) = refinery profit margin. Keeping in mind the 3-2-1 crack spread, the hypothetical prices above, and the fact that there are 42 gallons in each barrel, our calculation would look like this: (2*0.65*42) + (1*0.90*42) – (3*22) = 26.4. In this scenario, the refinery estimates that it can theoretically make $8.80 per barrel (the sum above divided by the three barrels of crude input) in August before operating costs.
Kendra: Ok, got it. So, May is currently closing out around $11 and news outlets are describing June contracts (currently trading around $22/bbl) as being “down.” They’re certainly not down compared to May pricing, are we describing this higher price as being “down” compared to how June contracts were previously pricing?
Barry: When we reference crude oil prices we are referring to the NY futures market price (which in itself is a financial derivative instrument) and not the “physical” market. You can currently buy or sell “future” contracts for crude oil going out monthly for the next three years, and each of these 36 monthly contracts trade at a different price, based upon market expectations, and move up or down every day. So, on a day like today, almost all the months are trading lower, from their closing price on Friday. (That is why June is also “down” today). The spot May 2020 futures contract expires tomorrow (Tuesday) and is extremely volatile. The term “spot” applies to the nearest futures contract month, in this case May. So, on Wednesday (the 22nd) the spot contract will be June 2020. There are two ways to “settle” a futures contract. First, and easiest is to settle with dollars passing between the buyer and seller for the value of the futures contract. Alternatively (and very rare) the buyer or seller can demand physical settlement of the contract at Cushing, Oklahoma, but almost all of the available storage at Cushing is either full or already committed, so there is no more room to stuff the crude someone wants to physically deliver – therefore the price keeps dropping until the person cries uncle. Some traders have gone so far as to charter very large crude carriers (VLCCs) – capable of holding two-million barrels of crude – for up to six months, just to store excess crude oil in the hopes that prices recover and they can sell it at a profit.
Kendra: So, with storage essentially full… what do producer margins look like? They don’t have the option to store their product (or won’t soon), so does their margin go negative? Are they already or will they soon be essentially paying buyers to take their product? Presumably they’d shut down at that point (or ideally before). But I seem to remember hearing that crude prices were negative somewhere, meaning that producers were LITERALLY paying “buyers” to take the crude away. Is that really the case? Seems crazy. I can envision negative margins, but negative prices seem impossible.
Barry: Actually, yes, for some Canadian crude oil the price is already NEGATIVE $5-8 per barrel. For U.S. shale producers, their breakeven point to produce is around $35-40 per barrel. So the Saudi and Russian strategy was to put so much crude on the market that it becomes painful for U.S. shale producers to keeping pumping, they will be forced to shut down the well and wait for higher prices, thereby removing crude oil from the market leaving the Saudis and Russians with a larger market share. The huge problem now, not foreseen by the Saudis or Russians, is the effect of Covid-19 which has dramatically sucked 40% of worldwide demand for oil out of the market.
Kendra: Wow, that’s unbelievable. I knew about and understood the Saudi/Russia and Covid effects, but I did NOT realize sellers were actually PAYING buyers in some markets – like the Canadian example you gave above. That’s just insane. Has this ever happened before to WTI? Negative prices?
Barry: For some Canadian crude, yes, but only briefly. Never for WTI at Cushing. Even at crude prices this low, though, some refiners cannot sell their refined products and cover operating costs, so they lose cash on every barrel of crude they run. That is why some refineries (like Marathon at Martinez) are shutting down.
Kendra: Do any U.S. or Canadian producers have what it takes to weather this? Or are we just left with Saudi and Russian options when all is said and done?
Barry: Shell/Exxon/Chevron, etc. can keep pumping but not the smaller independents. It feels like there is at least one bankruptcy announced a day in Houston, which is going to leave bankers holding worthless loans for hundreds of millions of dollars.
Kendra: Yikes. Not a pretty picture. So, we’ve been talking about negative crude prices. Have there also been negative refined products prices? You indicated that refiners are losing money on each barrel they produce, but I think of refiners as “purchasing” crude, processing it, then selling it (unless they’re vertically integrated), so if crude prices are super low and gas prices haven’t totally cratered it seems like refiners’ margins should have improved.
Barry: There have never been negative product prices, but the margin (or crack spread as explained above) is negative at the moment after taking into account refinery operating costs. As you indicated, refinery margin = revenue from products sales, less operating costs, less the price of crude. But product prices are down given declining demand and rapidly building refined products inventories
Kendra: Got it.
Barry: Bloomberg is now reporting that “buyers in Texas are offering as little as $2 a barrel for some oil streams, raising the possibility that American producers may soon have to pay customers to take crude off their hands.”
Kendra: Yikes. It just keeps dropping off the cliff! For the crudes that are now pricing in the negative, have those producers already shut down? If not, why not?
Barry: For some producers, completely shutting down is not an option, because doing so could permanently damage the physical structure of the underground reservoir. Those producers will reduce to minimum flows. For the others, they are in the process of shutting down. It is not like throwing a light switch because it costs extra money to shut down and then extra money again to start back up. Therefore, if some think the market will quickly self-correct, they may do nothing. Risk vs. reward.
Kendra: Ahhh. I knew that was the case for refiners. Didn’t realize it was also the case for crude producers.
Barry: For some producers, prices below $35/bbl cause them to lose money because the cost of extraction is so high on some of the production fields. People estimate the cost of extraction for Saudi to be on average about $8/bbl while in the U.S. for some it could be $30-40. Some of the really old Saudi fields only cost $2/bbl to produce the next barrel.
Kendra: Different crudes sell at different prices because of their quality (and ease of refining), right? So, difficulty of extraction and also quality of crude all play into the picture. Is there any correlation between difficulty of extraction and quality (cleanliness and “flavor” or whatever) of the crude? Or are those totally unrelated?
Barry: Each crude is worth a different amount to individual refiners based upon their processing unit configuration. There really is no linkage between “quality” and “cost of extraction”. In fact, most of the shale production from Texas is very high quality but expensive to produce.
Kendra: Ok, so I can’t expect all the really “nasty” crudes (in quality or methodology of production) to be the first to go. Was looking for a silver lining…
Barry: Nope. There are crudes from California that are tar-like but very cheap to produce because the fields have been active for 75 years. Bottom line – everyone in the oil business except retail service station owners are hurting. Some retailers are making over $1 per gallon, which is why prices at the pump are still much higher than they should be.
Kendra: I suppose even with the 50% decline in gasoline demand we’re seeing, if margin per gallon is high enough, they could still be making profits similar to before even though selling fewer gallons. Yes?
Barry: Think of it this way: In the past, a good retail margin was $0.30/gallon so at half the volume but three times the margin they are still ok.
Kendra: Makes sense. So they’re… “optimizing revenue streams.”
Barry: Retailers are also losing revenue on their convenience store sales. A typical station sells about 150,000 gallons a month of fuel but also generates $150,000 in store sales with a $0.30 margin on the gasoline and a 30% margin on the store sales.
Kendra: So… why don’t the retailers without convenience stores lower prices to suck up more market share?
Barry: Because without the extra revenue from the store sales, even if it is half, it is hard to reduce the price of gasoline way down and still cover your fixed costs – rent, salaries, electricity, insurance, taxes, etc.
Kendra: “Artificially high” (though nominally lower) gasoline prices seem a little suspicious, don’t they, though? Price gouging on essentials isn’t allowed, and I would assume fuel is an essential. With retailers seeing such an increase in margins, how is that not considered “gouging”? Is that because they aren’t raising prices, just keeping them at their pre-COVID prices?
Barry: Absolutely correct. If they drop pump prices just a little bit, the motoring public is happy and the regulators don’t catch on to what’s really happening (giant jump in retail margins). Anyway, just to let you know, the final price for May WTI crude futures was just posted at NEGATIVE $38.50 per barrel.
Kendra: Woah! Historic low, I’m assuming?
Barry: Yes. This is the first time WTI has ever traded less than zero.
Kendra: OUCH! Who sold barrels at that price?
Barry: Your guess is as good as mine. I am sure there were very few contracts traded at that price, since beginning one day before expiration the exchange begins to contact all the holders of material long and short positions and strongly suggests they liquidate their positions, with assistance from their brokers. It is doubtful any oil company or reputable trader was involved with the last couple of trades. They were probably doctors or dentists who forgot about their positions or did not understand the rules for delivery. Also, normal cash margin requirements for futures contacts is about 10%. As the contract approaches expiration, the margin requirement ratchets up to ensure the future contract holder has the funds necessary to settle their account. Anyway, this was fun. I’ve gotta go make my weekly trip to the supermarket.
Kendra: Sounds good! Thanks for answering all my questions. Stay safe out there.
Do you have a question for Barry or another Stillwater Associate about what’s happening in the crude market or how to manage the effects on your business? Our team of highly-experienced experts is here to help. Contact us!