Perspectives

Auburn Economics professor comments on oil prices

Dr. Hyeongwoo Kim, economics professor and department chair

A unique combination of a pandemic, stay-at-home orders and an ongoing price war between the world's top oil producers has led to historically low oil prices and a growing global crisis. To help sort out how we got to this point, and what lies ahead, we spoke to Hyeongwoo Kim, Patrick E. Molony Professor & Department Chair of Economics

Kim's research focuses on empirical models of exchange rates, financial asset prices and commodity prices. He received his BA, MA in Economics (Cum Laude), from Seoul National University
and his Ph.D. in Economics, from The Ohio State University.

Negative oil prices? What’s happening?
On Monday, April 20, the price of U.S. crude oil (West Texas Intermediate, WTI) fell into negative territory for the first time in history: as low as -$37.63 a barrel. A negative price means that sellers offer money to buyers to take the oil off their hands. In fact, oil prices have started to decline rapidly since January 2020 due to the COVID-19 crisis, but a negative price?

This severe price crash was driven by a temporary technical blip. WTI May delivery futures contracts were due to expire on Tuesday, April 22; that is, holders of May futures were supposed to take delivery of the physical crude oil when the contract expires. Unlike oil refinery companies, these investors — or, should I say, speculators — don’t have any intention to take delivery of oil. Normally, they would be able to roll over futures contracts, easily switching to longer-dated contracts (e.g., June delivery) before the expiry date. Unfortunately, they were unable to do so this time, as the demand for crude oil has declined substantially due to the global COVID-19 lockdown.

Furthermore, the U.S. is running out of space to store a glut of crude oil, making it extremely difficult and expensive to store oil if the delivery actually occurs. This pushes investors to offload those futures holdings at a deep discount to avoid substantial monetary costs. It should be noted, however, that this phenomenon is temporary. The contract eventually settled at $10.01 a barrel on Tuesday. This $47.64 rise in the span of a single day demonstrates the extremely high volatility. Note also that the June WTI contract price started declining substantially, though still positive. It is highly likely it would follow a similar pattern as the May contract as long as the COVID-19 crisis-related uncertainty remains high. We may observe oil prices being negative around May 19 when the June WTI contract expires.

Why are oil prices so low currently in the U.S.?
Since January, oil prices have rapidly decreased in not only the U.S., but everywhere else. All three benchmark oil prices — Brent, Dubai and WTI — have plummeted since the outbreak of the COVID-19 pandemic. Why is this happening? Prices are determined by demand and supply. We all know the demand for oil has decreased due to international travel bans and lockdowns as a result of the COVID-19 crisis. But we also have heard that OPEC+ (Saudi Arabia and Russia are major participants) have agreed to cut oil production with help from President Trump. Ultimately, this will decrease the global supply of oil. If both the demand and supply decrease by an equal amount, prices will remain about the same. Therefore, declining oil prices suggest that the decrease in demand is overpowering the decrease in supply.

The COVID-19 pandemic has been ripping through the U.S. economy. Initial jobless claims skyrocketed to nearly 7 million at the end of March – a stark contrast from the previous highest record of less than 0.7 million in 1982. The U.S. economy simply stopped working. Many economists declare that the coronavirus has triggered a global recession. Some claim that this downturn will be far deeper and longer than that of 2008. These concerns surely dominated seemingly fragile quantity collusion to reduce the production of oil, resulting in rapidly declining oil prices. 

What is likely to happen next?

I would interpret this question as: How and when will the U.S. economy recover? Oil prices tend to be low during recessions, while they go up when the economy recovers. According to a recent poll by Reuters, roughly 50% of respondents said the U.S. economic recovery would be “U” shaped instead of “V” shaped, meaning that the U.S. economy’s recovery is likely to be long and painful.

However, I may point out that we learned a lesson from the Great Recession in 2007-08. Policymakers are taking extremely aggressive measures. The Fed has lowered the federal funds rate target down to zero percent and announced it will buy bonds (inject money into the market) as needed to stabilize financial markets — even corporate debt using emergency lending programs. In addition, the federal government is providing huge stimulus packages that include Economic Impact Payments (stimulus checks) and the Paycheck Protection Program, which would help avoid deep recession. Recession is surely underway. How deep and long it will last depend on how we handle this crisis.

Also, I should point out that this question greatly depends on when COVID-19 vaccines will become available. If a treatment or a vaccine is likely to arrive shortly, policymakers may open the economy sooner, which will minimize the duration of recession. If it takes a long time to develop vaccines, however, we will have to be ready to fight long and painful deep recession, as we may have to open and close the economy several times in response to waves of the coronavirus.

What does this all mean for American consumers?

Consumers may benefit from low oil prices as long as they are able to maintain their same level of income. Since they pay less money for gas and energy, they might be able to purchase more consumption goods. However, if low oil price is a consequence of economic downturn, this may not be true. The average household income declines during recessions. Therefore, even if oil price goes down, consumers may have to downsize all consumption goods, including energy products, as your real income decreases even more.

Recessions can also further exacerbate income inequality problems across households. For example, the Fed’s expansionary monetary policy actions, such as quantitative easing, tend to help boost financial asset markets like the stock market. Since rich people have a better access to asset markets via savings than poorer people, the former tends to recover their income more quickly, generating greater inequality.

How can oil companies survive this?

I am not an expert to this question. However, I heard lots of U.S. oil companies, including shale gas firms, wouldn’t be able to survive much longer. The so-called “Fracking Revolution” led by technological breakthrough (e.g., hydraulic fracturing techniques) made it possible for the U.S. oil industry to rapidly rise since 2009. I am afraid to say it would be extremely difficult for them to survive unless the federal government provides sufficient help selectively to those with innovative technologies.

Last Updated: April 23, 2020