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Why is Gas so cheap now? - Cheap Gas from Cheap Oil Part 2 (Is It Good or bad?)

Posted by: Erik Bjornstad

As the coronavirus pandemic spread in 2020 and the consequences hit oil markets, lost in the shuffle was the fact that oil prices dropped to lows not seen in a generation. Consequently, average gas prices also dropped down to levels not seen since the years immediately following 9/11 - almost twenty years ago.

 

Blog - Cheap Gas From Cheap Oil Pt 2 0420

 

In Part 1 of our blog (read it here) on “Why are oil prices so low during the global pandemic?”, we laid the foundation for understanding some of the key factors that determine the price of oil and, consequently, the price we pay at the pump for gas and diesel. Here in Part 2, we’ll get down into the nitty-gritty details of why oil prices went so low as to drop into negative territory. More importantly, we’ll talk about the potential consequences for all of us - and why mega-low gasoline prices may not be the best thing.

Why The Price Of Oil Went Negative

In short, the reason oil futures prices dropped so low is because we had a whole lot of oil traders stuck with contracts that were getting ready to come due but who didn’t actually want the oil.

This makes sense. Oil traders don’t have any means of using or taking possession of the oil they trade for - they just buy and sell it. And even if they had a reason to get 40,000 gallons of oil delivered to them, there’s no place to put it because there’s no storage space left. We’ve already been producing more oil than we’ve been using since the start of the pandemic, and all that excess oil has to be stored somewhere (that’s another story, but fully detailing it would make this blog post three times longer than it already is). 

Remember, these oil traders have to take delivery of the oil if the contract reaches its maturity date -  there’s no option for them to defer it. So they try to do what they’ve always done and sell it on the open market. But this time there’s no demand for the contracts (see the previous paragraphs for reasons).  Now they’re all in a really big bind. SOMEONE somewhere will take the oil off their hands….for a steep price. But that’s still less than it would cost them to actually have to take ownership of the oil (or pay the penalties for not doing so by the maturity date).

And so that is why we have a situation where one party would want to pay another party for the privilege of not having something they’ve already bought.

Too Much Supply For The Demand? Why Not Just Make Less?

In weighing all these facts, a logical question might be if there’s a problem with too much oil supply, why can’t they just turn things off until they use up the excess?

It’s nowhere near as simple as that question implies. In order to get oil prices stabilized (i.e. make them go back up), the demand needs to be greater than the supply. And there’s problems with trying to artificially increase or depress either side.

On the demand side, we’ve seen that it takes a “black swan” event like a global pandemic to force global demand for oil to drop by 20-30%. That’s what’s been happening. Yet there’s no corollary to increasing demand by that much. You can’t just invent ways to use 30% more oil. That means even when demand for oil returns to normal, it’s going to take a long time to get rid of all the excess that we’ve built up. 

Speaking of price issues, we haven’t even addressed the role of the Saudis and the Russians in this whole thing. Without going into too much detail, they helped kick this whole crisis off at the beginning of the pandemic by offering steep discounts for the oil they were producing. This started and accelerated the oil price drop that’s been made worse by the huge glut of oil we now have since the demand has dropped by 30%.  Why would they do that? A conspiracy theorist would tell you it’s because they want to destroy our economy. A non-conspiracy theorist would say both the Saudis and Russians have every incentive to see our oil economy go down the tubes, so there’s more than a grain of truth to that.

On the supply side, one of the biggest misconceptions about oil is that you can simply “turn things off and on”. That doesn’t take into account the production equipment and the financial obligations, both of which make this option all but impossible. The oil production and refining system, with its machinery and infrastructure, simply aren’t designed to be turned off or even run below certain minimum production levels. It’s all built on the assumption of a minimum amount of oil being produced.  

Not only is it impossible to turn the system on and off like the average person thinks, there are also legal contracts and insurance swaps in play, all of which require certain amounts of oil to be produced at any given time, at the risk of huge financial penalties for failure. 

What this all means…...the economic hole that has been dug for us from the coronavirus pandemic isn’t one that we’re going to recover from in a couple of months. 

Why This Matters (In Other Words, Why Low Low Gas Prices Aren’t Always Great)

You may be reading all of this and thinking I like low gas prices. Why in the world would I want oil to go up?

This is where we have to see the big picture. Yes, low gas prices save us all money at the pump. But this is a really dangerous situation for areas of the world that have economies tied heavily to oil. Places like Western Alberta, Canada. 

So what? I don’t live there. But low gas prices do save me money, and my household needs that. 

Okay, fine. Low gas prices save us money - money that many of us really need. Yet, the world’s economies are all inter-linked. The rest of Canada relies on the oil money from Western Alberta, both for taxes (more than $20 billion Canadian a year just in taxes paid by the industry + $500 billion in income taxes) and for all the salaries the 500,000 workers are making that buy things everywhere else. The United States relies on that money too, to the extent that the Canadian economy is linked to the USA as a big trading partner. You don’t care about Canada? There’s all the areas of the United States tied integrally to oil -- places in North and South Dakota and Texas and Oklahoma. 

Just how badly is the current situation going to affect a place like Western Canada? We look at the numbers for hints. Before all this started, Alberta had already committed to a budget that relied on assumptions about their oil revenue. It relied on a certain amount of oil being produced that would be sold at a certain price. To be precise, the expectation was more than $4 billion in oil royalties coming from 3.7 million barrels of oil produced per day, selling at a price of about $51 Canadian. Oh, and an assumed exchange rate of $0.76 (0.76 Canadian dollars for every 1 US dollar) - this matters because the United States is the single biggest buyer of Canadian oil.

What will the real numbers look like? As of late-April, oil from Alberta wasn’t trading for $51 a barrel, it was trading for $4.23 a barrel. Production wasn’t at 3.7 million barrels a day, it was only 90% of that (and projected to go down to only 50% of that). And for the kicker, even the exchange is only at $0.71, meaning all of the lower income they’re making is worth even less.  

Depending on how you crunch the numbers, this could mean a 95% drop in tax revenue from the oil royalties (from $20 billion down to $1 billion) and a huge drop in income tax revenues. Folks, the economy in Western Canada, so centrally-tied to oil, is going to get really ugly.

There’s no easy answer to all of this and this problem isn’t going to go away quickly. It may take years for the oil market to stabilize. When it does, our gas prices may go back up, but it will be better for our economy and our national health overall. 

This post was published on May 13, 2020 and was updated on May 13, 2020.

Topics: Fuel Policy