The graph below shows spot prices for three crude benchmarks: WTI (Cushing, Oklahoma); Light Louisiana Sweet (St James); and Brent (North Sea).
LLS is coastal, and Brent is seaborne, so it's relatively straightforward to arrange transport for these benchmarks. WTI is inland, which means it needs to be transported via fixed pipelines, by rail, or by truck. For this reason, the difference between WTI and LLS typically reflects the marginal cost of transport between the two hubs.
When we observe the spread between LLS and WTI widen, it's typically an indication that the marginal cost of transport from Cushing to the Gulf Coast has increased. Note that current prices for LLS and Brent are still very much in line with one another, despite the thousands of miles separating the two reference points, as shipping is relatively straightforward to arrange.
The negative prices observed for WTI have been attributed to the fact that storage in Cushing is near capacity. And clearly, storing a barrel in Cushing for a month and delivering into the June WTI contract would be an option for people able to arrange storage. But it's worth remembering that an alternative to storing a barrel in Cushing is to transport the barrel elsewhere, where crude is selling for a higher price.
I've seen people suggesting that the higher price for June WTI futures suggests that oil market participants are expecting a rapid economic recovery in the US. Given the economics of storage and transport, I believe these comments are incorrect. Rather, the price difference reflects the fact that market participants believe they have time to contract for June storage and/or transport at reasonable rates. It's difficult to increase storage and pipeline capacity on short notice, but it is possible to arrange for additional rail cars and tanker trucks to travel to Cushing for June delivery. And in the meantime, traders now have plenty of time (and incentive) to close long positions well ahead of delivery.
One of the cheaper means of storing crude is to simply leave it in the ground. And of course that's the decision that the Saudis and Russians would like US producers to make. But some of these producers have hedged the prices they receive by selling the crude forward, including via the futures market. And in that case, they have every incentive to continue producing and to deliver their barrels at the agreed prices. But at some point, these hedges will roll off, in which case many of these producers will be facing spot and forward prices that are well below their marginal production costs.
Why isn't the Federal government taking advantage of these negative prices to further fill the strategic petroleum reserves? The SPR storage facilities are all along the Gulf Coast, so the managers of the SPR face the same transport bottlenecks as the rest of the market.
Are we likely to see negative prices for the June 2020 WTI contract, particularly going into delivery? Given the relatively inelastic nature of storage and pipeline transport capacity, it's a distinct possibility, particularly if producers have sold forward a lot of production using the June futures contract. In that case, I'd be concerned that the extra rail cars and tanker trucks that can brought into the region over the next month may be insufficient. My expectation is that one month is sufficient time for the market to make arrangements to avoid a fiasco of the sort seen this week, but I don't have data on actual production sold forward, so this is only a hunch.
Finally, it's worth noting that the debacle in Cushing this week ultimately stems from the fact that there isn't sufficient capacity to transport all the crude that the market would like to see transported to the Gulf Coast. And this is a common theme developing during this COVID-19 pandemic. In many places, there's an insufficient number of ICU beds, an insufficient number of ventilators, an insufficient number of masks and gloves, an insufficient number of test kits, and an insufficient number of trained medical personnel. There's insufficient capacity to get dairy products and produce into retail channels. Many places have insufficient broadband capacity as more people work from home.
Just-in-time practices have improved capital efficiency under normal circumstances, but of course they're not robust to disruptions. And I suspect we'll be seeing more investment in infrastructure that would be judged inefficient during normal circumstances but that would be greatly appreciated during crises. At least I hope so.
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