Selling (Going Short) Crude Oil Futures to Profit from a Fall in Crude Oil Prices

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Effect of falling oil prices

A fall in oil prices should cause a reduction in transport and fuel costs for firms. Consumers who will also benefit from the lower prices of transport and fuel. The lower oil prices will effectively increase their disposable income and enable them to spend more on other goods

Because oil is the most traded commodity and has a significant bearing on global transport costs, it should lead to inflation and can lead to higher rates of economic growth.

However, sometimes oil prices crash because there are fears of an economic recession. In this case, falling oil prices are not sufficient to increase economic growth because other factors keep growth low. Also, if oil prices fall sufficiently, it can cause some oil firms to go out of business and this causes a rise in bad debts.

Also, falling oil prices will have differing effects depending on the country. Oil importing countries (e.g. Germany, Japan, India) will generally benefit from oil lower prices, but developing economies who rely on oil exports (e.g. Russia, Venezuela) could see a significant fall in export revenue.

Oil price fall 2020

The oil price fall in March 2020 has pushed oil to its lowest prices for many years. The above graph shows nominal prices and not adjusted for inflation.

Usually, a fall in oil prices would be greeted by consumers and firms due to the lower prices and costs. However, this fall is due to expectations of a sharp drop in travel and economic recession from the coronavirus. Therefore, there is little expectation that the lower oil prices will have any positive economic effect. If people cut back on travel, cheaper petrol doesn’t make much difference. If people see a fall in income because they are out of work, cheaper oil prices are only a small compensation.

More detail on lower oil prices

Products made from petroleum

Oil is a commodity used not just in petrol and diesel but many other products, such as

  • Motor oil, plastics, clothes, solar panels, floor wax, ink, bearing grease and other 40 everyday products (Products made from petroleum)
  • Therefore, many goods will see a marginal fall in cost of production when oil prices fall.

Impact of lower oil prices on oil consumers

Lower oil prices help to reduce the cost of living. In particular, if a household owns a car or uses other forms of transport reliant on oil. To a lesser extent, all goods should become cheaper due to lower transport costs.

Falling oil prices in 2008 and 2020 contributed to lower inflation.

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This fall in the cost of living is especially important if real wage growth is low which has been the case in recent years. A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Problem of Bad debts

In 2020, oil prices have fallen so far that the price of oil is selling for a lower price than the cost price for producers in US and Russia. Saudi Arabia has pushed the price below $30. But, this damages many oil firms have who borrowed to invest in new oil fields. This could lead to firms closing down and going bust.

Macroeconomic impact of falling oil prices

  1. Lower inflation
  2. Higher output

This diagram shows that a fall in oil prices (and a fall in firms costs) will shift the short-run aggregate supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say on average a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)

3. Balance of payments

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have a limited impact on UK current account.

Oil exporters

For oil exporters, a fall in oil price is damaging to the economy. Many oil-exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela have relied in the past on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves.

Why falling oil prices is not enough for Europe?

Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.

Other economic impacts of lower oil prices

Reduced profitability for alternative energy sources. In recent years, there has been an incentive to invest in renewable energy and electric cars. A prolonged fall in oil prices will reduce this incentive and encourage firms and consumers to stick with oil.

Falling oil prices could delay investment into alternative ‘greener’ forms of energy, such as electric cars, and this could have negative consequences

Long-term falling oil prices could reverse the recent decline in-car use, leading to a steady increase in traffic congestion and environmental costs of petrol use. (see: post on case for increasing tax on petrol)

Evaluation

A few years ago, oil prices were rising through the roof, and many expected high oil prices to be the new norm. It is unlikely OPEC will want to tolerate low oil prices for too long. There is still a strong latent demand in Asia (India and China). The coronavirus could prove to be a very severe economic shock, which leads to a deep recession in 2020. However, it will not last – experts predict by 3-6 months, the worst should be over. This could cause a strong economic recovery and prices quickly bounce back.

Example – effect of falling oil prices on Russian economy

The Russian economy is highly dependent on the oil and gas industry. The fall in oil prices caused a rapid devaluation in the Rouble and contributed to a recession.

Crude Oil futures

Crude Oil futures chart

Here at FxPro, we’re delighted to offer our clients the opportunity to trade CFDs on Crude Oil Futures. Light Sweet Crude Oil (WTI) futures are traded on the NYMEX (New York Mercantile Exchange), which recently entered the CME Group. This futures contract is the most actively traded oil contract in the world. WTI means the West Texas Intermediate Crude Oil. This brand is used to the production of gasoline, diesel and other common types of fuel and therefore is subject to consistently high demand, primarily in the receiving country – the United States. Actually, futures is a standardized forward contract to buy or sell an asset at a predetermined price at a specified time, known as an expiration date. If you want to diversify your trader’s portfolio invested in non-correlated asset class, take a closer look at the price fluctuations of the Crude Oil Futures.

On this page, you can take a look at the live chart to make your own responsible decision to buy or to sell this Contract for Difference (CFD) through the FxPro trading platforms. To start trading, open your FxPro Direct account by clicking the “Register” button at the top of this page. Several convenient top-up methods with 0% commissions are available.

Trading Conditions

Crude Oil Futures Calendar

Month Ticker Start Trading Trading only for closing positions Expiration date
January 2020 #US_Oil_F9 15/11/2020 17/12/2020 19/12/2020
February 2020 #US_Oil_G9 17/12/2020 18/01/2020 22/01/2020
March 2020 #US_Oil_H9 18/01/2020 18/02/2020 20/02/2020
April 2020 #US_Oil_J9 18/02/2020 18/03/2020 20/03/2020
May 2020 #US_Oil_K9 18/03/2020 17/04/2020 22/04/2020
June 2020 #US_Oil_M9 17/04/2020 17/05/2020 21/05/2020
July 2020 #US_Oil_N9 17/05/2020 18/06/2020 20/06/2020
August 2020 #US_Oil_Q9 18/06/2020 18/07/2020 22/07/2020
September 2020 #US_Oil_U9 18/07/2020 16/08/2020 20/08/2020
October 2020 #US_Oil_V9 16/08/2020 18/09/2020 20/09/2020
November 2020 #US_Oil_X9 18/09/2020 18/10/2020 22/10/2020
December 2020 #US_Oil_Z9 18/10/2020 18/11/2020 20/11/2020
January 2020 #USOil_F20 18/11/2020 17/12/2020 19/12/2020
February 2020 #USOil_G20 17/12/2020 17/01/2020 21/01/2020
March 2020 #USOil_H20 17/01/2020 18/02/2020 20/02/2020
April 2020 #USOil_J20 18/02/2020 18/03/2020 20/03/2020
May 2020 #USOil_K20 18/03/2020 17/04/2020 21/04/2020
June 2020 #USOil_M20 17/04/2020 15/05/2020 19/05/2020
July 2020 #USOil_N20 15/05/2020 18/06/2020 22/06/2020
August 2020 #USOil_Q20 18/06/2020 17/07/2020 21/07/2020
September 2020 #USOil_U20 17/07/2020 18/08/2020 20/08/2020
October 2020 #USOil_V20 18/08/2020 18/09/2020 22/09/2020
November 2020 #USOil_X20 18/09/2020 16/10/2020 20/10/2020
December 2020 #USOil_Z20 16/10/2020 18/11/2020 20/11/2020

Trading time (UK time) Sunday – Friday: 11:00 PM – 10:00 PM
Closes daily between (10:00 PM – 11:00 PM UK Time)
Closing Time of a Contract At Expiration Date:07:30 PM UK Time

* Only if Margin Level > 100%

** Margin applies for volumes up to 50 lots. Please refer to Futures Leverage Information for larger volumes

The impact of plummeting crude oil prices on company finances

Crude awakening

What has caused the sudden fall in oil price? What effect will this have on the industry? Who will be the winners and who will be the losers? Our recent article provides a view of the impact the plummeting crude oil price will have on company finances.

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The collapse of crude oil prices in the second half of 2020 caught many by surprise. The price of Brent crude fell more than 50 per cent from $115 per barrel (bbl) in June to below $50/bbl by early January in 2020 and shows no sign of reaching the bottom just yet. For four years up to June 2020 oil prices had remained consistently above the $100/bbl mark, which the Saudi oil minister, Ali Al-Naimi, viewed as the optimum price to balance the market between crude oil price producers and consumers.

Figure 1. Brent crude oil price Source: Bloomberg

The last fall of this magnitude was during the financial crisis: in July 2008 prices were approaching $150/bbl, but had plummeted to below $50/bbl by the end of the year. This dramatic price collapse was in response to severe recession in many countries. However, the fall proved to be temporary and oil prices were back up above $100/bbl by early 2020.

The causes of the current prices collapse are not as dramatic. There has been no major world economic shock. Indeed the world economy is growing, although the recovery is not as rapid or as widespread as many have hoped.

So why have oil prices more than halved? And what impact will these have on company finances in 2020? After years of relative stability, giving rise to confidence and investment in the oil and gas sector, major uncertainty is now being reflected in company balance sheets.

Why has this happened? Because supply growth…

While growth in global demand has been subdued in recent years, supply – mainly from non-OPEC producing countries – has increased leading to a surplus of oil in the market. In a November 2020 analysis, Citibank estimated that supply was exceeding demand by 700,000 barrels per day (bpd). This resulted in a build-up of oil inventories. For example, crude oil production in the United States has increased significantly in recent years: the country produced nine million bpd in 2020 compared with five million bpd in 2008 (see Figure 2). This has been possible because years of historically high and stable crude oil prices made shale oil projects – mainly in North Dakota and Texas – economically viable.

Figure 2. Global oil production and Brent crude price
*Includes natural gas liquids and non conventional oils
Source: IEA, Bloomberg

The mission of OPEC, as stated in its charter, is “the stabilisation of prices in international oil markets”. In the past, when oil prices were falling, OPEC would usually intervene in the market by cutting output to support prices. However, at its last meeting in November OPEC responded to the current surge in supply by maintaining production levels. At the time of the meeting the oil price was just over $70/bbl. In the three weeks following the Vienna meeting prices fell by a further $10/bbl and triggered a near ten per cent sell-off of crude inventories in a single day.

Many OPEC countries in the Middle East have taken advantage of the low costs of onshore oil production. As shown in Figure 3, the average cost of extracting oil from onshore fields in the Middle East is $27/bbl, less than half the cost of extracting North American shale ($65/bbl).

Figure 3. Average cost of crude oil production
Source: Rystad Energy, Morgan Stanley Commodity Research estimates

While the move to maintain current levels of production may sustain OPEC’s market share, it will increase pressure on high-cost producers, particularly in North America, who have increased production rapidly in the past decade. At present OPEC accounts for roughly one-third of total global oil production.

…failed to meet demand expectations

Although the global economy continues to recover, growth has been weaker and slower than many expected. For example, weak Chinese data continues to cause concern and growth in Japan and the eurozone remains fragile at best.

Total European crude oil consumption fell to 14.3 million bpd in 2020 from 15.3 million bpd in 2009, and 2020 levels may even be below 2020 figures. European economies are still grappling with weak growth and low inflation, making the threat of a third recession in six years a real possibility. Indeed, the European Central Bank announced that inflation in December was -0.2 per cent. The challenges are similar in Japan, where demand has dropped from five million bpd in 2007 to four million bpd in 2020. If households in Europe and Japan are encouraged to save by the prospect of cheaper goods tomorrow and companies delay investment for the same reason, then economic growth will come under further pressure.

Can shale survive in a lower-price environment?

While producers have been seeing their revenues decrease and debt levels swell since June 2020, share prices of US shale producers have been steadily falling. This makes the short-term outlook for many shale oil projects very challenging, and the prospect of bankruptcy for low-margin producers is quickly becoming a reality.

The sector is facing serious funding difficulties that could have an almost immediate impact on production. The US shale sector’s main source of funding is debt. Most producers invest more cash than they earn and make up the difference by issuing bonds. According to The Economist, cumulative debt in the US shale industry is climbing and stood at $260 billion in December, and more than double the 2009 level. Debt to gross cash flow has doubled since the beginning of 2020. This means that the growth of debt is outpacing cash flow growth from investments in operations leading to shale producers becoming highly geared. Investors and debt markets are likely to become more reluctant to fund further investment, which could lead to a significant decrease in the number of US shale projects. As shale oil wells deplete more quickly than conventional wells – output can fall by 60-70 per cent in the first year – any slowdown in investment can translate into an almost immediate decline in production.

According to Barclays investment research, energy bonds made up nearly 16 per cent of the $1.3 trillion junk bond market in 2020, more than three times the proportion a decade ago. In addition, nearly 45 per cent of non-investment grade syndicated loans (anything below a BBB rating) issued in 2020 were in oil and gas, which could lead to many financial institutions holding unrecoverable debt on their balance sheets. Research from Alliance Bernstein suggests that the exposure of banks could be significant. For instance, Wells Fargo has participated in $37 billion of non-investment grade loans and JP Morgan is also heavily exposed with $31.7 billion loans to the energy sector.

Other high cost projects such as Canadian oil sands, the UK Continental Shelf and offshore Arctic drilling are also likely to become more challenging in a lower price environment as potential investors become concerned by increasing price volatility.

Yet the long-term future of shale oil seems more promising. Analysts believe that currently a median US shale project needs a crude price of $57bbl as opposed to $70bbl last summer. This is because larger players are able to produce oil more efficiently as they begin to achieve economies of scale. A shale oil well can also be drilled in as little as a week, at a cost as low as $1.5 million, which enables producers to react quickly to market conditions.

Winners and losers

The net effect of cheaper oil is expected to be positive on global growth. According to The Economist’s estimates, a $40/bbl price cut could shift some $1.3 trillion from producers to consumers through direct savings at the petrol pump, leaving households with more resources for discretionary spending in other parts of the economy, including goods and services.

However, most crude oil exporting countries are facing challenging times. Russia is heavily dependent on its oil revenues, with oil and gas accounting for 70 per cent of total export revenues. According to a Foreign Ministry adviser, Russia loses about $2 billion in revenue for every dollar fall in the oil price. The country’s state-owned Sberbank says oil prices need to stay above $104/bbl for the government budget to be balanced.

The economic sanctions imposed on Russia in the wake of the crisis in Ukraine have been exacerbated by the collapse of the oil price leading to capital flight of around $134 billion in 2020. The Russian Central Bank has forecast further capital outflows of $120 billion in 2020, $75 billion in 2020 and $55 billion in 2020. In addition, many Russian energy companies – among others – had borrowed substantially in non-rouble currencies from European banks and financial institutions during the years of high oil prices. These investments are now increasingly at risk of default and could further weaken the banking industry and financial markets throughout Europe.

The rouble hit a low of 62 per dollar on 8 January 2020 compared to 35 at the start of last year. In response, the Russian Central Bank raised interest rates overnight from 10.5 per cent to 17 per cent, just five days after the previous increase, in an effort to stop the rouble sell-off and keep inflation in check. Furthermore, in its latest warning, the Russian Central Bank warned that if oil prices remained at $60/bbl, the economy would likely contract by 4.5 to 4.7 per cent in 2020.

Most OPEC countries have little room to manoeuvre because of their reliance on oil revenues to balance national budgets. These include Iran (where oil prices of around $130/bbl are needed to balance the national budget), Venezuela, Iraq and Nigeria. Unlike the Gulf states (Kuwait, for example, requires a price in the mid-$50/bbl to balance its budget), they have no large foreign exchange reserves to fall back on to sustain state expenditure and the oil price collapse has been exacerbated by existing problems such as sanctions, political instability, security and corruption. Nigeria, for example, has been recently forced to raise interest rates and devalue its currency the naira.

By contrast, Saudi Arabia has $741 billion of currency reserves and posted a $15 billion surplus at the end of its last fiscal year. This means that it can run budget deficits for several years without causing major harm to the country’s finances.

The impact of falling oil prices on oil company finances

The most obvious impact of the oil price collapse on company accounts is the increased risk of impairment of assets. Lower oil price forecasts mean that producers should expect lower future profits from an asset. Subsequently, this reduces the present value of the asset, and if the value currently carried on balance sheets cannot be recovered in full, this results in write-off. There may also be a knock-on effect on related deferred tax and holding company investment balances.

Rapidly changing oil prices make it difficult to judge the present value of assets for investment decisions on capital allocation, an acquisition or for accounting impairment purposes. Companies often apply forward curves in their valuation models. A recent Financial Times article demonstrates just how quickly forward price curves have changed, underlining the difficulty in judging the correct present value of an asset (see Figure 4). Valuation models look at a range of sensitivities and scenarios. The $60/bbl oil price that used to be the lower end assumption in models for many companies has now become a reality.

Figure 4. Evolution of Brent crude oil forecasts

Note: Each line represents the spot price, the 3 month forecast and 12 month forecast as available on the survey date indicated in the legend
Source: Consensus Economics

Lower operating cash inflows will inevitably lead to capital expenditure cuts and the potential write-off of exploration assets. In December, when crude oil was trading at $70/bbl, Goldman Sachs estimated that almost $1 trillion of spending on future oil projects was at risk.

In addition, reduced operating cash flows can ultimately result in business failure, so company boards will need to give greater consideration to judging whether the going concern basis of accounting, (i.e. whether the company is able to continue trading for the foreseeable future) is appropriate.

Companies may also find renegotiating debt challenging. At times of high oil prices, refinancing existing debt either through bank borrowings or issuing new bonds tends to be relatively straightforward. However, lower asset values and increased default risks mean that borrowers will face increasing challenges, including the need to pay higher interest rates or enhance security packages, if they are able to borrow in the first place. The price deck utilised by reserve base lenders (RBLs) may also be reduced significantly, leading to a reduction of RBL facilities and the acceleration of debt repayment schedules, putting even more strain on company balance sheets.

At times of high commodity price volatility, mergers and acquisitions activity can pick up. For example, Ophir has recently made an offer for Salamander Energy, Repsol acquired Talisman in December and there are rumours of other potential acquisitions among explorers and producers. This might be a good time for those with available cash to acquire distressed junior players. When cash flow problems are present, corporate purchases can take place at bargain prices as a result of investors being forced to exit their investment quickly and realise cash at any price. However, this is rare and only tends to occur in extreme circumstances, as most vendors prefer to hold onto their investment until they get a better offer, if they are not being offered what they consider to be a fair value. When businesses change hands at bargain prices, the purchaser recognises a day one gain on the ‘negative goodwill’ arising in the acquisition and this is recorded immediately as profit (as opposed to positive ‘normal goodwill’ which arises where a purchaser has paid a premium for a business, rather than a discount, and which is carried on the balance sheet).

More companies may also return to hedge accounting, which was increasingly used in the wake of the financial crisis. With prices consistently above $100/bbl, most exploration and production companies were able to make profits without needing to hedge. However, many companies, especially large players, continued to pay for price hedging instruments as ‘insurance’ against a price fall. Lower prices may mean more producing companies, including smaller ones, could resort to ‘locking down’ their output with hedging instruments. Hedging instruments may become effective for accounting purposes, and companies that have maintained price hedges (for instance, for a price floor of $80/bbl) will find that these are now ‘in the money’. After an extended period of taking ineffective volatility through the profit and loss account, companies which adopted a policy of hedge accounting may need to take part of the gains through hedging reserves for the first time in years. For purchasers of fuel such as airlines and bus companies with hedges in place to cap prices, the effect will be the opposite and hedges become ineffective.

Finally, lower pricing leads to higher counterparty credit risk where counterparties are dependent on oil prices for cash flow. Where a company is part of a joint venture (JV), there could be an increased risk of JV partners being unable to fund their share of liabilities – including decommissioning costs – and this could result in other partners having to take on their share, putting increasing pressure on their own cash reserves.

Conclusion

The oil price collapse has given rise to a high level of uncertainty, which is being reflected in company balance sheets. After years of relative price stability, investor confidence in the oil and gas sector has plummeted, and for the moment there is little reason for confidence to return. The question most asked in the industry is whether this is ultimately a long-term downward structural adjustment in the price of oil or a short-term temporary correction. A number of recent analyst forecasts confidently point to a recovery back up to $80/bbl by the end of 2020. Whether they are right or wrong, the continuing uncertainty means that 2020 certainly looks like being a hugely challenging year for oil companies, oil producing countries and global policymakers.

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