It’s amazing what dead white European males can tell us. For example, David Ricardo, who published this insight in 1817, can explain why the oil price is about to go negative.
Sadly this doesn’t mean that we’ll be able to pull up at the petrol station and be paid to fill up. The claim is not that all oil prices everywhere are going to go negative, rather than some of them, in some places, will do so.
The explanation is Ricardo’s Law of One Price. The same thing will cost the same amount in every geographic location, once we’ve accounted for a few trivial corrections. Most notably, the cost of transport of that thing to those different places.
The oil market is a global one, something we can see just by considering those vast tankers shipping the stuff around the world. Oil is also, largely enough, substitutable. There are differences, heavy and light, sweet and sour (little sulphur or lots there), but by and large we can adjust a refinery to make what we want, petrol, aviation fuel, and so on, from any version of crude oil. Such commodities are, in the technical term, “fungible.”
We update Ricardo to say these days that fungible items will be the same price around the world minus taxes and transport. An Apple iPhone is the same wholesale price everywhere. A barrel of oil from anywhere is the same price when delivered. We’ll not pay more for oil from Venezuela than we will from Saudi Arabia that is.
Running this back the other way, this means that the transport costs are hugely important to the original producer. If we’ll pay just that one price for oil delivered then higher transport costs to get it to us will fall on the people running the oil well. Which is what does happen. There are various listed oil prices out there, Brent (North Sea oil), WTI (Texas), Bonny (Nigeria), and the price differences are partly to do with the quality of the oil (that thick or thin, sweet or sour) and mostly to do with the transport costs from the production point.
One of these listed prices is Western Canadian Select, WCS, and that’s currently running at $5 or a little less. Yes, the global oil price is $20 a barrel, or whatever it is by the time this is published, but WCS is $5. Because this is the price for crude oil stuck out in the middle of Western Canada. It costs money to transport if from there.
There aren’t that many pipelines doing it, it’s a long way from the sea and those supertankers, most of it moves by train. And trains are expensive things, especially when the oil industry is already making the network run at full capacity.
In fact, one sub-grade here, bitumen (that’s the really thick stuff) is currently selling for $0.95. That’s 95 US cents per barrel, not $95.
That’s not a negative price of course but it could easily become so. For this comes up against another idea, that it’s sometimes worth losing money now in order to make more in the future.
As we’ve all noticed the global economy has slowed down a lot as a result of Covid-19. A slower global economy means we’re all going to use less oil so we’d expect a price fall. Unfortunately for those in the oil industry this has coincided with Saudi Arabia deciding to launch an oil price war. The precise reasons they don’t concern us here but think about power politics and cartels for an explanation.
The Saudis are therefore pumping at maximum ability right now -- that means a fall in demand is being met by a rise in supply. The price therefore goes into freefall, as it just has done.
The solution is for some oil production to stop. Yet that can be difficult. To stop extracting from a field can mean losing the ability to ever extract some portion of what is left in that field. Any producer thus faces the calculation well, do I keep pumping even though I’m losing money in order not to lose more in the long term.
It works posing the question the other way around, should I lose money now to make it up in the future? The usual answer is yes, up to a point, then no.
Combine these two together and it’s possible to see how the oil price, at certain remote production points, could become negative. Actually, I’d go a little stronger than could, probably will. For yes, everyone’s got some storage capability in their oil field but once that’s full? They face damaging the long term production, paying people to haul it away or leave it to leak out all over the ground -- and that last is illegal.
“What’s the use of economics?” is a fair old question for a great deal of what is said in the subject is wrong. But the correct answer is that it helps us explain the world around us. As here, a principle, that of one price, laid down and explained before anyone even started drilling for oil on any large scale, explains to use why certain oil prices are about to go negative.
And what’s the point of any science other than to explain to us why things are as they are?
Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.
