• Roger Chang

Negatively Charged Oil Prices

In late April 2020, oil prices hit an unprecedented negative value of minus US$37.63 per barrel of oil. Traders were paying others good money to receive and store oil commodities on their behalf. While the reality is that regular consumers like you and me likely never see a situation where we get paid to collect petroleum products, let’s examine how negative oil prices could become the new normal, the part electric vehicles have to play, and how it will affect us all.

Why So Negative

Petroleum products form the backbone of our modern industrialized society. They power everything and are an essential ingredient in most of our consumer products: from the elastic fibers in your underwear to the circuit boards in your device allowing you to read this article. Our civilization cannot function without petroleum, and as such demand for it is rather like old underwear: inelastic (unaffected by price).

As demand is inelastic, oil prices are primarily determined by its supply. Toward this end, the Organization of Petroleum Exporting Countries (OPEC) regulates the world’s oil supply by setting production limits on its member nations. Limited supply equals higher prices, and the OPEC members get more dollars for their finite oil resources. Great deal, and everyone is happy.

Then this year Russia decided not to play nice with OPEC and kept up their oil production. Everyone flooded the market with cheap oil. Subsequently, COVID-19 became a pandemic and forced industrial production worldwide to halt. This killed oil demand with a ruthlessness that environmentalists could only dream of.

The perfect storm of excess supply and almost no demand massively dropped oil prices. All that excess oil also meant that most oil storage facilities were filled to the brim.

Oil prices are determined by futures contracts, an agreement that obligates a seller to provide a commodity and a buyer to receive it upon expiry. Emphasis here on ‘obligates’. Furthermore, futures contracts are mostly traded by financial institutions with no means of storing any oil whatsoever. Oil is rather toxic, and would definitely ruin the lush carpets in their cushy offices.

Thus, when the April contract expiry rolled around, these institutions rushed to offload their futures. Most storage facilities were at capacity, driving down prices even further into the negative range.

The New Normal

As we have seen, the negative oil prices are the result of oversupply and weak demand. I would argue that incidents like this will become more common within the decade. One of the reasons is electric vehicles (EV).

In the US, around 70% of oil is used as transportation fuel. Even if we were to argue that only lighter EVs are feasible (ignoring the upcoming Tesla Semi and developments by Volvo, Mercedes, BYD and a whole host of other companies), 45% of oil is used as gasoline. That 45-70% of oil use will be impacted as EVs make up a larger share of the total road vehicles.

One may argue that EVs represent only a small sliver of the market and thus have little effect. However, this is bound to change soon. The price of lithium ion batteries (which form the bulk of an EV’s cost) are predicted to dip below $100 per kWh in 2023. At this price, EVs would cost the same as its fossil fuel equivalents. Factor in the significantly lower costs of running an EV, and we are looking at a cheaper, cleaner and zippier alternative to the old gas vehicles.

What does a market do when an appreciably superior option appears? It switches to that option rapidly. We have seen such disruptive market shifts in other product categories – VHS superseded by DVDs, thick cathode ray displays replaced by sleek LCD panels, incandescent light bulbs swapped for LED bulbs, buttoned mobile phones displaced by smartphones, and so on.

As consumers cotton-on to the new technology, economies of scale start to kick and further bring its cost down. Other players enter the market to provide peripheral services (example: EV charging infrastructure), increasing the utility of the technology. This accelerates adoption of the technology until its growth becomes exponential - taking over the market in short order.

Exponential growth means that we will not see the sudden wave of electric vehicles surging onto the market. You would be hard-pressed to find anyone not using a smartphone these days; the first iPhone was introduced a mere 12 years ago.

So, what happens when 70% of oil’s utility use suddenly drops out of the market?

Dump It All

The oil producing nations are not dumb; they are aware of what will happen to their oil reserves when demand for oil drops precipitously – they will suddenly become stuck with stranded assets. An oil field that cannot be developed because the demand and price of oil is too low is a stranded asset - one that can never provide economic benefit to its owner.

Therefore, even before EVs become a significant part of the market, we are going to see a massive dumping of oil on to the market. After all, it is better to capitalize on what little demand is left today, than to be left with an unsellable asset in the future. OPEC would not be able to enforce production quotas, as nations rushed to cash in on remaining demand. This would create a situation similar to what has happened with the OPEC-Russia price war earlier this year, and the subsequent negative oil prices.

What It Means For Us

Will we one day be paid to fill up our fossil fuel car at the pump?

Unfortunately, no. This is as oil prices only constitute 60% of pump prices (during “normal” times). The rest of the price you pay goes towards the refining and production of petrol, distribution of the fuel, marketing costs, and taxes. Nonetheless, we can expect petrol to be cheaper at the pump.

As for whether this would slow down the adoption of electric vehicles, it remains to be seen how much cheaper petrol would become. Currently, the cost to run an EV is one third that of a regular petrol car. That requires pump prices to drop very significantly.

On the flip side, low oil prices may paradoxically reduce the cost of buying an electric vehicle. This is because a lot of the components in an EV require oil to produce. There is also the advantage that EVs have in terms of acceleration and lack of local pollution. Therefore, it is likely that low oil prices will hardly impact the adoption of electric vehicles.

Regardless of how fast EVs supplant oil demand, we are eventually going to see more oil shocks. The consequences are going to be hard to predict, but they will be far ranging. We are entering a brave new world. Expect great changes, upheavals, and renewals as we head towards a cleaner future without fossil fuels.

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