EPISODE 170

Pricing Oil and Hedging Risk in Uncharted Markets

65 minutes · April 15, 2020

The economic rigor mortis from COVID-19 has reduced the global demand for oil by more than 30%. The result has oil producers and refiners scrambling to find tanks to store their products and sent the price of a barrel plunging in some of the largest single day drops in history. Mike Wittner, ICE’s Head of Oil Market Research, joined the podcast to discuss how companies and investors are managing their risk during this unprecedented uncertainty, and how markets will be impacted for years to come.

Speaker 1:

From the library of the New York Stock Exchange at the corner of Wall and Broad Streets in New York City, you're Inside the ICE House. Our podcast from Intercontinental Exchange on markets, leadership and vision and global business. The dream drivers that have made the NYSE an indispensable institution of global growth for over 225 years. Each week, we feature stories of those who hatch plans, create jobs and harness the engine of capitalism. Right here, right now, at the NYSE and at ICE's exchanges and clearing houses around the world. And now welcome Inside the ICE House. Here's your host, Josh King of Intercontinental Exchange.

Josh King:

As we get ready to record this episode, the price of a gallon of gas at Hickory Hill Market, which my friend and neighbor, Jim Miltenberger opened last year in Windham, New York is, wait for it, $2.28. All winter long, the price had held steady at 2.69 or thereabouts. Thousands of miles away at a virtual meeting about to begin between the OPEC nations in Russia. The cost of a barrel of oil hangs in the balance. Even before, the meeting gets underway, just in the hope that a deal will be struck to cut production. Brent crude was 4.5% higher at about $34.30 cents a barrel.

Josh King:

Now, regular listeners of this show might remember the voice of Helima Croft at RBC Capital Markets. She's a global oil expert and she interviewed Intercontinental Exchange's founder, chairman, and CEO, Jeff Sprecher live on stage in Dubai just a few months ago in November. A span that today seems like an eternity, when Brent was trading around $62 a barrel. Six months later quoted in the FT today. Helima said, she expected that, as I'm going to quote her. "Meetings will yield a broad framework agreement to curb output by a big headline number, but that it would likely fall short on hard specifics, such as duration, implementation, timeline and enforcement mechanisms."

Josh King:

Now, you'll remember that Intercontinental Exchange was founded 20 years ago in modernized energy markets. Today, it's the home of global energy pricing responsible for that Brent global oil benchmark, as well as a number of other important benchmarks. And we've been watching the news just like Helima Croft with banner headlines varying with versions of, the global oil markets are broken. Spread across energy market publications before it became mainstream press. In any other time, this story would've driven the A-block on all the major business outlets across the globe, but instead it's been relegated to a supplemental story about the damage that the coronavirus was having on society and the economy.

Josh King:

The subject remains popular around ICE's virtual water cooler, and today we're going to be joined by Mike Wittner. The person who's responsible for understanding and analyzing the oil markets for the company. All eyes are on that meeting between OPEC and Russia for the first time, since 1986, when president Ronald Reagan dispatched his Vice President George HW Bush to Saudi Arabia. The US finds itself on the side of the debate, supporting a dramatic reduction in production. What we don't know, as we sit here today, how that meeting will play out. One thing is clear. Any supply side actions will require the Russian, Saudi price war to be resolved.

Josh King:

Our conversation with ICE's head of global oil markets research on what's happening in the global energy markets. How the US found itself reversing four decades of energy policy. And if the oil market is indeed broken. That's right after this.

Speaker 3:

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Josh King:

Our guest today, Mike Wittner is head of oil market research at Intercontinental Exchange. Mike leads ICE's research effort to continuously analyze and anticipate changes in oil market structure and fundamentals to help create new contracts and evolving existing contracts to meet the hedging, trading and investment needs of its customers around the world. Mike was previously the head of oil research for Societe Generale Corporate and Investment Banking, and held a similar position at Credit Agricole. As well as a senior analytical role at Koch Supply & Trading, the International Energy Agency and PIRA Energy Group, which is now part of S& P Global Platts. Before getting his MBA, Mike worked as a geologist and project manager for an engineering firm and as an analyst at the Central Intelligence Agency. Mike Wittner, welcome Inside the ICE House.

Mike Wittner:

Thank you very much.

Josh King:

Before we begin, I've been watching headlines stream across my screen, Twitter following at OPEC. Do we have any updates from the ninth extraordinary OPEC and non OPEC ministerial meeting held via a webinar in light of the recent development surrounding the COVID-19 pandemic?

Mike Wittner:

There's no hard views right now. There's been sort of a frenzy of speculation in the last few days, as happens before every OPEC meeting. But right now, it's too early to know how this is going to play out. The one thing also worth reminding our listeners is, after today, there's already going to be scheduled tomorrow, a G20 meeting that countries such as the US, Canada and Brazil, who are not part of OPEC Plus. They're going to be talking about oil as well. So this is really just part one of at least a two step process.

Josh King:

You joined ICE about six months ago from Societe Generale, where risk and energy risk magazines included you in its top researcher list for over a decade, Mike. Including the number one oil market researcher for the last seven years. Before we get your take on how you see oil markets today, how does someone become a top ranked oil researcher?

Mike Wittner:

You got to work really hard and have to know your stuff. But aside from that, I think you need to be very objective and fight against biases that you may have in your analysis, be conscious of them and recognize biases in the information and even the data that you're looking at. That's one thing. And then you really have to have the courage of your convictions. It's kind of like being a baseball empire. You got to call them as you see them. I think clients appreciate that. It's not good to have a reputation as somebody who's always bullish or always bearish. Again, whatever the market is telling you, whatever your analysis is telling you. That's what you need to say.

Mike Wittner:

You need to listen to your clients. That's really important and you need to be a good communicator. It's not just the analysis, but it's about whether it's in writing or a one-to-one meeting or a big presentation at a big conference. You need to be able to explain in an understandable way and at the right level, you need to be able to explain your analysis. So all that's important.

Josh King:

I mentioned at the outset, your training as a geologist, your stint at the CIA. I'm curious, going back into your past, how do you become passionate about geology, passionate about oil, finding it endlessly fascinating as you do?

Mike Wittner:

I knew when I was an undergraduate studying geology, I knew then that I wanted to get into the oil business. That's for sure. And it took me a while to get there. I didn't really do that until after I got my MBA, but then once I started in analysis, I just find it really fascinating because there's so much going on. It's not just about numbers. I love the geopolitics where obviously I got some expertise in that at the CIA. There's always something new. That's the bottom line. It never gets boring or rarely gets boring.

Josh King:

Were your parents engineers or scientists? How did they steer you in that field?

Mike Wittner:

No, not at all. My dad was an import, export. My mom had a full career as a teacher in a New York City public school system. When I was in college and went off to work in South Dakota as a rough neck on a drill rig, as a summer job. They thought I was absolutely nuts. No steerage from my parents at all.

Josh King:

Have you been back to South Dakota during the shale boom and see how things have changed since your time there on a drill rig?

Mike Wittner:

No, actually I've not been back there, but I miss it.

Josh King:

I'm sure you miss it. I mean, when you first get up in the morning, what are you reading to get a pulse of the market and how quickly do issues evolve normally, as opposed to what we're seeing right now.

Mike Wittner:

First thing in the morning is check what crude prices are. I mean, right there, if you see like a big increase or decrease from the previous day, you know something happened and you need to do some more homework. Obviously, checking work emails. Because again, if there's been a big change overnight, we're going to hear about it really fast. Then I check the business press, Wall Street Journal, Financial Times, sources like that from macro type of news, because that can be very important for the oil markets. Just to look at what's been going on recently with the coronavirus and the global economy.

Mike Wittner:

There's a daily oil trade press, where you start getting into some fairly nitty-gritty reports, daily reports from different sources that tell you what's been going on and sort of basically help flag emerging issues. So that's sort of a typical start to the day.

Josh King:

Since, you joined the company, the price of barrel of oil on the world's leading oil benchmark. ICE brand crude has plummeted. Before, we dive into the dynamics driving the market. Can you give the audience a quick overview of how the oil markets function and what it means when we refer to the physical market versus the paper market for crude oil?

Mike Wittner:

Yeah, let me take the second one first, when we talk about the physical markets and the paper markets. Physical markets that's real crude. That's a real barrel of actual crude oil that a company produces and sells to a refiner. That's going to refine it into gasoline and diesel and jet fuel. Those are the physical markets. The paper markets are the derivative markets. That's the futures markets, the options markets. That's what we do here at ICE, to provide markets to trade those things. So that's the difference when we talk about physical or paper and they're very closely connected. As a matter of fact, it starts to become news and something to analyze, when they start to become a little disconnected, which is something we've been seeing recently a little bit, but that's a difference. It's real oil versus derivatives.

Mike Wittner:

On the other question, how do the oil markets function? I would put it this way. What drives oil prices? Kind of three broad sets of factors, by far top of the list the primary driver or the fundamentals of oil. So that's supply, demand and inventories. Oil traders, oil market analysts, and others spend a lot of time trying to understand those things. What's been happening? What's happening now? And forecasting what is going to happen. And other things can affect oil prices. Ultimately, sooner or later, everything does come back to the fundamentals. Because again, somebody needs to produce a barrel. Somebody needs to refine a barrel and end users need to consume refined products.

Mike Wittner:

The second factor, or the second group of factors are non-fundamentals, such as investor flows, money coming in and out of the oil markets. It's you usually based also on fundamentals, but investor flows can exaggerate price moves, can add momentum to price moves in both directions. So it's important to understand, when that's happening and when that's playing a role in the oil markets. And then third group of factors is geopolitics. The easy example is, if there's a threat of a war in the Middle East, it's going to affect the oil markets. So you need to understand what's going on there, keep track of different issues around the world and so forth. So fundamentals, non-fundamental factors, like investor flows and then geopolitics. That's what really drives the functioning, the price formation of oil.

Josh King:

And as we talk at this moment, the price formation of oil Brent's June contract is trading for just over $30 a barrel, a price the markets have not seen since the oil price collapse in 2016. Between 2014 and 2016, the price of oil fell 70%, the largest drop in history. How does that compare to the current market over the last six months and is there anything we can learn from how the events of that last period played out?

Mike Wittner:

Actually, the comparison you made in 2014 to '16 crude prices dropped by 70%. From the beginning of this year, January 2nd up until the tail end of March, crude prices dropped by about the same level. I think it was 66 or 67%. As you mentioned, prices have bounced a little bit higher in recent days in anticipation of this OPEC meeting that we discussed. But the price drops were very, broadly similar, but the big difference this time is it happened so fast. Back then we thought that was a steep price decline. It took place over, two months, three months. This time it happened in a matter of weeks. And that applies I think to a lot of what's going on in the markets today, both prices and fundamentals.

Mike Wittner:

It's not just the what's happening, but it's how fast it's been happening is really important. On what we can learn from last time. I mean, there's a lot we can learn from last time. One again, the fundamentals do matter. The initial trigger or what set the stage for 2014 was the huge growth that had been taking place over a number of years. But that finally reached a tipping point. The huge growth in US shale oil production. That really set the stage. And then what really caused the absolute collapse was the reaction of Saudi Arabia and OPEC to US shale.

Mike Wittner:

In other words, they said, "You know what? We can't fight this. We can't keep chipping away at production to try to prop up prices, because all we're doing is helping the US." So they went the other way, a very dramatic swing and kind of took their hands off the steering wheel and said, "You know what? Let's produce close to all out and let prices sort out the market." One lesson is fundamentals, matter a hell of a lot. And number two, what OPEC does or does not do also matters a hell of a lot. And there's some interesting parallels to what's going on right now.

Josh King:

So I want to talk about those parallels for a second because the drop last decade was spurred by this increase in supplies you said, but the current markets are being hit by a demand shock from the coronavirus and a supply shock from this Saudi, Russia price dispute. Help someone who's just tuning in recently over the last eight weeks or so because we just sort of woke up to this price dispute. Those who aren't like you following it minute by minute, day by day. What are the origins of the dispute and can you quantify the changes the markets are seeing on the demand and supply sides as a result?

Mike Wittner:

That's what makes this one unique. I think almost in history or at least going back to the '80s, which is a little bit before my time. And when I say that, we have simultaneous demand shocks and supply shocks, 2014 was a supply shock. The Great Recession of 2008, 2009 was a demand shock. The economy heads south, demand gets weak, oil prices drop and other recessions have been similar. In 1986, the Saudis really ramped up oil production at that point. So again, that was on the supply side. This is different because we have both happening at the same time. So just to kind of frame it up in, in terms of the numbers by far the coronavirus and the impact on the global economy and the impact on oil demand is much bigger.

Mike Wittner:

The estimates have been going up every week, but it now seems that ... The consensus is that, in April oil demand is going to be down 30 million barrels a day, give or take. That's a staggering number. Just for reference, the sort of pre-coronavirus the market was about a 100 million barrel a day market, which is nice, because it makes the arithmetic easy. We're talking about a 30% drop in consumption because of a virus in a matter of weeks, less than two months for sure. We have 30 million barrels versus the supply shock that comes from the Saudi, Russia price dispute, price war. That's on the order of two and a half to three million barrels a day, which back just one month ago when OPEC Plus fell apart. They had a meeting and the Saudis and the Russians could not agree at all. Two and a half million barrels a day at that point seemed like a really big deal. But now, compared to what we've seen on the demand side, it's not as big.

Mike Wittner:

So that's point one. Point two, the origins of the dispute. So OPEC Plus, the two key players have always been the Saudis. They're kind of the defacto leader of OPEC. And then there's a bunch of non-OPEC countries that have been cooperating with OPEC since late 2016. So that's where the plus, in OPEC Plus comes from. But bottom line is, the only country in OPEC Plus that matters is Russia. Everyone else is just noise, to be honest. In terms of decision making and in terms of what they do as far as cutting production.

Mike Wittner:

A month ago, the Saudis proposed to the Russians, "Hey, we need to cut ... " At that point, no one knew how bad coronavirus was going to get, as far as the impact on the economy. At that point, the Saudis were proposing, "Hey, let's cut production by ... " I think it was one and a half million barrels a day. And the Russians said, "No." And this'll sound familiar because I mentioned already, the Russians said, "If we cut production to prop up prices, all we're doing is helping the Americans. Helping US shale producers." And Russia had really been saying that fairly publicly ever since December, 2016. So at that point again, the situation was bad enough. So they kind of grudgingly came to the table with the Saudis and reached an agreement.

Mike Wittner:

All along, they've objected to sort of helping out the US, as a free rider, benefiting from what the Saudis and Russians were doing. One month ago the Russians basically said, "No, we've had enough. We're not going to do that anymore." So it's a dispute between the Saudis and the Russians, but it's really a triangle because it's the Saudis, the Russians and the US. And so really nothing's changed since late ... Well, since 2014. November 14, when the Saudis said, "Hey, you know what? Let's produce all out lower prices and hurt US producers."

Mike Wittner:

So the back then the Saudis were sort of the instigator. Now it's the Russians that are the instigator. On the receiving end in both cases and currently is the US. So think of it as a triangle. Those are the three key players right now.

Josh King:

Yeah. You mentioned this oil love triangle between the Saudis, the Russians and the US. And I want to jump off from there into one of the fundamental you mentioned earlier, which is storage. And a lot of people don't really sort of focus on this that much. But I mentioned this long line of oil tankers waiting just offshore during our recent episode of this program that we did with Kevin O'Leary. The physical manifestation of what the Council on Foreign Relations termed this week in a report. Oil's ground zero running out of storage. What's the correlation between energy and storage prices. And why do oil prices need to be so low to make storage profitable?

Mike Wittner:

So clearly there's a huge oversupply right now in a market, both of crude oil and refined products. Nobody's driving, nobody's flying, et cetera in countries and regions around the world. So what happens is, that oversupply something has to happen to it. A crude producer is producing that barrel. It has to go somewhere. How's the price set. You have buyers and you have sellers. When markets are tight, when demand is healthy and there may not be enough supply in the world. If you're a refiner, you're going to be calling, say Saudi Arabia or Nigeria and saying, "I need a cargo. Do you have anything?" They're anxious to get that supply. So they bid up the prices in a physical market, which is very connected to the front of the forward curve. So prices get bid up.

Mike Wittner:

Well, in a situation like now, it's the opposite. The refiners really ... They have too much crude and they're not calling anyone. They're sitting back and taking phone calls. So when Saudi Arabia or Nigeria or Chevron or whoever or Occidental Petroleum. When that call comes in and say, "Do you want some crude? We have plenty." The answer's going to be, "I'm not too worried. I have a lot. What's your price?" And they'll name a price. And they'll say, "I don't know, the phone is ringing off the hook. I got someone on the other line offering me the same thing. Think about your price and call me back later." The seller has to cut their price and the buyer may or may not be interested because they really don't need it. So prices again, in the physical market and at the front of the forward curve tend to go down.

Mike Wittner:

That's the current situation. Bring it back to storage. I have too much crude. Let's use the example of crude oil. I have too much crude. I want to put it in a tank. What happens? Well, putting it in storage. It's not free, it cost money. If you're a oil producer or a physical oil trader, you need to make money. So how do you make money by putting it in storage? Whether you're buying or selling oil or stocks or bonds or whatever, the way to make money is, you buy low and sell high. So right now, in the oil market, I'm going to buy that cheap barrel of crude to put into a tank. As soon as I get off the phone with that physical producer, I go on my ICE screen and I immediately ... I just bought a crude say at $30 a barrel, and say I want to store for six months. I immediately go and say, "Okay, what's that forward contract worth six months forward" It's going to be, I don't know, $12 higher. I'm going to sell that forward right now. I just locked in a profit. It doesn't matter what the hell happens to prices, in the meantime. I've locked in a profit right now.

Mike Wittner:

So second part of it is, "Okay, well how much does that cost? What does that do to prices?" Just to throw a little bit of jargon in there. That's called contango in the oil markets, it's like dancing. It's called contango. The contango has to be steep enough, so the difference between that crude that I just bought and the forward price that I just sold. Again, six months forward. I'm just making these numbers up. That difference has to be big enough to pay for that storage and leave me a little left or for my profit. Say that costs $10 a barrel over that six months. Well, if the difference between right now and six months forward is only nine dollars barrel. It doesn't work, because that profit that I'm going to lock in, doesn't pay for the rental of that tanker. But if the difference between the price now, and the price in six months, the contango, in other words. If the front falls a bit more and all of a sudden, instead of $9, it's $12. And I'm only paying 10 bucks to rent that tanker. Now I'm going to do it, because I can make money at it.

Mike Wittner:

In the oil markets, we call that, crude has to price into storage, which means that oversupply is going to keep pushing down and pushing down on prices at the front until that forward curve, until that discount at the front becomes steep enough that will let you profitable put that crude into storage. So that's a dynamic we're in right now. You just started a self-reinforcing process. And what do I mean by that? So this is sort of the econ 101, or oil markets 101 of how it works is, the entire market is looking every week. For example, the US oil stats that everyone follows that came out yesterday. They say, "Okay, inventories just went up. Gosh, I have even more oversupply." That's going to put even more downward pressure on prices at the front. What does that do? Ah, that gives me now a little more room, a little more profit margin to put crude into storage. So I'm going to do that based on that little example I just gave.

Mike Wittner:

What happens? Well, next week, if everyone is putting crude into storage and by the way, this is happening around the world. Again, just using a US example. Next week, when the stats come out, I'm going to see inventories went up again and that's bearish. So the price is going to go down even further, which is going to increase the incentive, the profit margin to put more crude into storage. And the same thing happens over and over again. So this is kind of the self-reinforcing cycle of how weak markets push down on the front. Crude goes into storage. It pushes even further down on the front. You put more in storage and so on and so forth.

Josh King:

With this contango that we're seeing now. I mean, are there any historical parallels? Have you ever seen a storage shortage like this?

Mike Wittner:

At this point, I would say yes. So what has the market so hyped up is, it's an anticipated build up in storage. The consensus again, is that we have somewhere between 750 million barrels, 950 million barrels. I mean, there's a range of estimates of available storage on land right now. And then there's also tankers, floating storage. It's not filled yet, but the markets are anticipating that again, given that 30 million barrel a day collapse in demand that, that's going to get filled up pretty darn quickly, like in the next month or two. So we're not there yet. We have had big storage builds in the past. That time period we were talking about earlier in late 2014. OPEC said, "Screw it. We're not going to manage the markets anymore. We're going to produce all out." And they started producing a lot of crude driving down prices.

Mike Wittner:

In 2015 and '16, there were equally concerns that we were going to run out of storage and oh, my God. What's going to happen? Prices are going to have to collapse to price into storage, just the way we talked about. We've had these concerns before and other periods of time as well, but we've never had it the oversupply be this big, this fast. I don't want to sound like a broke record, but that's what's making this different and what it has the markets really stressed out, and this is why you have the headlines or the oil market's broken. We've had the situation before. We've never actually run out of crude space, crude storage space before, despite the concerns that have happened previously in other episodes. But this time we might really do it. And that's what has markets kind of hyped.

Josh King:

So give us a sense of like how much remaining storage there is left globally. I mean, we all have a couple bathtubs in our homes. What are some of the more crazier inventive ideas for increasing storage that you've heard of? Any entrepreneur with a dream must think of how you quickly erect massive storage tanks in sort of unused property somewhere.

Mike Wittner:

First of all, on how much space is left right now, again maybe 750 million barrels to somewhere a little less than a one billion barrels and that's on land and that's crude and products. Those sound like really big numbers. But again, given the scale of the oversupply right now, we could fill them and we could fill that space up in 30 to 60 days. The typical places would be ... So this is sort of the non-creative. The usual places are at refineries, storage terminals, which could be an independent storage terminal, like Cushing. Just at a pipeline junction. It could be on a coastline somewhere. For example, the Amsterdam, Rotterdam, Amthor area in Northwest Europe is a big storage hub. Singapore is a big storage hub in Asia.

Mike Wittner:

So you have refineries, you have storage hubs, when you start to get creative. I mean, bathtubs, not a bad idea, but the more creative places tend to be what's not being used. Trains that transport crude oil. That's something that's pretty big in North America. Those trains probably aren't being used right now, because again, demand is collapsing. Crude production is starting to go down, so there's going to be trains unused. So you could fill up a train, just to keep it in the middle nowhere on a track siding somewhere. And you'll use that in a few months, when demand comes back. Barges on a river somewhere, that's another place. Again, trains and barges are usually used to transport crude, not to store crude, but you can get creative.

Mike Wittner:

I had already mentioned ships. That's kind of a floating storage. Again, that's very routine when the markets like this. That's kind of in your standard bag of tricks. Other than that, I don't know how much more creative you can get, but it is true that building tanks is not ... They have to obviously be built safely and to modern specifications, et cetera, but it's not rocket science to build tanks. So that can happen. But the key thing there is, the tank operators, the people who would ... The companies that would do that, they're not going to start building tanks right now because they want to see, "Well, how long is this going to last?" If they become convinced that this situation with this very steep contango in the market and with very high demand for storage. If they become convinced, "Hey, we're going to be at this for ... " The market will be oversupplied for a year or more. You're absolutely right. They might start building more tanks.

Mike Wittner:

So that's the sort of thing that can happen. Another creative thing is maybe a refinery, an older refinery that shut down or was mothballed just because it wasn't profitable for various reasons. Well, that refinery is probably still sitting there and it has tanks. So again, in this kind of situation, if the people involved believe that the situation will last for a while, then they'll de-mothballed that refinery and boom, you got some extra storage space. So things, like that.

Josh King:

Let's talk about some of the aspects of energy production and the cost to actually extract and acquire oil from the ground. It can vary from the US' shale fields, to Brazil's pre-salt fields, to what's going on today in the Middle East. Have more expensive production methods been forced to shut down and how widespread do you expect that to be? I mean, we were talking earlier about a nostalgic trip back to South Dakota, but it could become again, a ghost town, if this continues.

Mike Wittner:

By the way, the oil production is in North Dakota, not South Dakota, but we're close on that. There's two big subjects that have been huge in the oil markets. Again, in these daily reports and weekly reports in the last two, three weeks. One is storage, which we just talked about. We talked about how it works and where do you put it? And the other is, "All right, what's happening? How quickly are refineries shutting down or reducing their processing." And what you just asked about, how are producers responding? In order to shut down production, a producer usually has to believe that, "Hey, this is not a temporary blip." That prices are going to be low. Prices are going to be ugly for a while to come because shutting down production itself costs money and run some risks.

Mike Wittner:

Where's it going to happen? It's going to happen where prices are below cash operating costs for production and remember, I'm not talking about capital costs, say to develop a new field or drill a new well. I'm just talking about, just cash operating costs. The routine things that you need to keep the oil field running. So where's this happening? Well, we've already seen it happen. Up in Canada, they've shut ... The expression is shut in. They've shut in around 200 KBD, that we know of. There are reports of other companies that are considering doing it or maybe doing it. It's not clear. In Brazil, they've shut down also about 200 KBD. Again, all these numbers can go higher and will go higher.

Mike Wittner:

And really other than that, there's a lot of reports about worried producers that are considering shutdowns in places like the North Sea. In places like the US shale production and also what they call stripper well production, which are just really old wells that produce almost nothing, less than 15 barrels a day, not 15,000 barrels a day, but 15 barrels a day for one well. Those are thought to be at risk as well. The interesting thing is, there's something in common here between Canada and Brazil, which is they produce heavy crude oil. Heavy crude oil has high production costs because you normally need to do something like pump steam in to let that very thick viscus crude flow to the well. That costs a lot of money. So your operating costs are high.

Mike Wittner:

But the other thing, particularly for heavy crude is, when you shut in a well, you run a risk. A very real risk that you're permanently going to lose recoverable reserves. That a few months from now, when you turn it back on, the flow rates are not going to be as high as they were when you shut it down today or last week. And again that's because that crude is very sticky. It's very, viscus. It sticks to the pores of the rock formation underground. And sometimes, once you mess around with the pressure, gradients and things like that. Again, it just never comes back. So there's a concern.

Mike Wittner:

One quick word on US shale, because obviously there's a lot of focus on that. Again, after the Saudis opened up the taps in late '14 and the price crashed in 2015 and '16. US shale producers, it took about a six month lag and then, only then did US production start to come down. The reason is, shale is a different animal. We always talk about how it's so-called short cycle time. When bring a shale well on, the decline rates are incredibly steep. Those wells decline at around 70% that's 70 in one year on their own, a normal well. That's why shale producers have to constantly drill and drill to kind of keep production level, much less increase production. So last go round, the last price crash, not a single shale well in the entire US was actually ever shut down. They just stopped investing and the shale wells basically shut themselves in because of those steep decline rates.

Mike Wittner:

This time they're starting ... It's a little different because prices are lower and there are reports. There's been one report of one big producer that's already actually shut in some production and others are considering that. But again, shale producers have never done this before. Shale is still pretty new. So it's really not clear. I've seen conflicting reports on, if shale wells are also going to have issues of losing recoverable reserves, when they get turned back on a few months or a year or more down the road. So again, there's a reluctance to do that, because it does have risks.

Josh King:

The demand side issues that we've been talking about are unprecedented, but it was sort of predictable as the brakes were put on the global economy. On the other hand, this dispute between the Russians and the Saudis, it seems to be this classic oil market share battle that caught the world's largest energy players by surprise. So as we finish up the first half of our conversation, what do you think the outcome will be from all of this?

Mike Wittner:

We're talking about the meetings that are taking a place today and that will take place tomorrow. Let's face it they're rivals. They're they're rivals. They're the number two and three oil producers in the world. The US is number one. They're rivals that have been for the last three years until last month, they were kind of forced into bed with each other. They were forced to cooperate with each other. And they both, as we talked about, they're keeping an eye on the US, because the US has really been taken market share from both of them. And the US has been the beneficiary of their actions to prop up prices. For me, on balance. I think they're going to come up with some sort of agreement, but the wild card now is really the US.

Mike Wittner:

We've seen Trump and the US making a lot of statements in the last couple of weeks and the US as well as Canada and Brazil will be at this G20 meeting tomorrow. The current head, the president, the rotating head of the G20 is Saudi Arabia by coincidence. So tomorrow is sort of an integral part of what's going to happen today. Both the Russians and the Saudis have been saying almost every day up to and including yesterday. Maybe even this morning, that we're not going to do a deal unless the US participates. The US is saying, "Well, we're going to participate, but we're not going to shut in production the way you guys do. We're shutting in production because the market is telling us to and we're cutting investment."

Mike Wittner:

By coincidence, maybe it's not a coincidence. Tuesday, the official US Department of Energy forecast for US crude production was updated, big downward revisions. And basically, by the end of this year, and then again, by the end of next year. Starting now, the US is ... According to these official forecasts, US production is going down pretty steeply. We're talking, ballpark a million barrels a day between last month and the end of this year, and probably another million barrels a day a next year. So those cuts are pretty significant, but the US, if they choose to play the game has to dress it up and play along, if you will, with the Russians and the Saudis. And maybe try to package that as a so-called production cut.

Mike Wittner:

I tend to think that the Russians and the Saudis in the end will be forced to accept that as the US production cut and that they'll come up with a deal, but the deal is going to be missing a lot of details. It may not have country by country numbers. They may disagree on the schedule. They may have to leave it very wide open. There's probably not going to be an enforcement mechanism. There's going to be a lot of pieces missing, but I think they'll come up with something because they have to. That's the bottom line.

Josh King:

Talking about the free market after the break. Mike Wittner, head of oil market research at Intercontinental Exchange and I will discuss how companies and investors are going to manage their risk during this unprecedented uncertainty and how the energy markets will be impacted for years to come. That's right after this.

Speaker 3:

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Josh King:

Welcome back. Before the break, Mike Wittner, head of oil market research at Intercontinental Exchange and I were talking about the current state of the oil markets. The contango, the love triangle between the Saudis, the Russians and the Americans. Now, the massive plunge in oil prices has only occurred mainly due to the lockdown in the US. Once, the lockdown ends Mike, is a large portion of the demand likely to recover?

Mike Wittner:

The short answer is, eventually yes, but it's going to take time. Just to clarify or add to what you said. It's the lockdown in the US, but it's also the lockdown in Europe. It's the lockdown in Asia. China is loosening the reigns a bit, but very, very slowly. We can look at a lot of measures on the Chinese economy and it's coming back very gradually. I mean, I hope this doesn't happen, but in a taste of what might be ahead, you have countries in Asia, like South Korea, Japan, and Singapore that were very good early on at flattening the curve of the disease. They lock things down early, they've loosened up, but now they're getting a second wave of infections.

Mike Wittner:

It's going to be a very tricky thing to properly plan how to get the economy back on its feet. It will happen, but it's going to take some time. Again, just based on what we were already seeing in China, which is as you know, two months ahead of the rest of the world in dealing with this. Demand will come back. It's going to take some time.

Josh King:

I mean, just in terms of societal change Mike, there could be sort of real changes in the way people live their lives that ultimately consume less oil.

Mike Wittner:

In the post coronavirus world, that's a really big question. Is this going to have medium to long term impacts on the behavior of consumers, on the behavior of businesses that could perhaps permanently lower the rate of growth of global demand? Whatever the expected peak demand was going to be, maybe that peak comes sooner. Maybe that peak is going to be lower than it was, but you're absolutely right. As businesses and employees discover, "Hey, working from home is not so bad. We can actually do this." That could be a semi-permanent change. It would accelerate a trend that had already been slowly happening, but it kind of to push things along more quickly.

Mike Wittner:

There's other changes as well, aside from the demand side, this looks like it will affect the profile, the expected growth in US oil production, US shale oil. Perhaps, for years to come. It's going to change the way those oil companies and investors in those oil companies look at the market. So changes in US production and US exports, that has some ramifications for the global oil markets as well. So we could be in a different world going for forward. Very definitely.

Josh King:

A strange thing happened on the floor of the New York Stock Exchange a couple Fridays ago. Before, the trading floor actually closed, the White House was holding one of its daily briefings. I think they started at around 2:45, 3 o'clock and they were still going strong at 3:58, 2 minutes before the markets were expected to close. I think maybe the president or someone else had mentioned that one of the ideas to stabilize the markets would be included adding to the strategic petroleum reserves. And then the trading posts went crazy, as people tried to immediately absorb the ramifications of that possibility. Can the US government single handedly make a difference in what we're seeing in the markets?

Mike Wittner:

No, that's a short answer. I mean, that was an interesting idea for the US to ... The original idea was for the US to buy crude. Look, any demand would directionally be supportive of prices. I think when that idea was floated, what they did not say at that time, or at least in that setting. They had this idea, but actually had no funding from Congress to pay for that crude. And in the end, Congress did not allocate any money for it. So that idea is not happening. And the current idea is simply ... Again, going back to storage and now there's fear we're going to run out soon. The US still wants to fill the SPR, but there's something you got to offer that space, which is about 79 million barrels, which is really again, that's a drop in a bucket. But the US is going to offer that to lease that space to anyone who wants to use it and fill it up that way.

Mike Wittner:

But that's a very different thing than being a buyer in the market. They're just going to let people use that space. Given the scale and size of the demand collapse, given the size of the global oil markets, the US is not going to make a difference in that way. Again, I think the most likely way for the US to make a difference is in these talks now. If Russia and Saudi Arabia stick to their guns and say, "We need participation from the US." The US has to ... As distasteful as it might be politically or economically for traditional free market, the US way of doing things. The best way for them to support prices would be to somehow convince the Saudis and Russians that these cuts that the US is forecasting really, truly are their contribution to cutting production.

Mike Wittner:

The other thing that's on a table, which is really interesting is, there has been a lot of talk in recent week. And in recent days that the Texas Railroad Commission and at the Oklahoma Commission would once again, enforce production cuts among oil companies operating in their states. That has not been done since the '70s. There's a lot of opposition within the oil industry to doing that. There's a handful of companies that want to do it, and they're kind of pushing that idea. If that would work though, hypothetically, that could make a difference, because Texas has most of the Permian Basin and that would make potentially a very big difference in the oil markets.

Mike Wittner:

And again, all these things, whether it's the Texas Railroad Commission or OPEC, it's not just the barrels, it's sending a signal to the markets that the producers are trying to do something. Again, I used the phrase before, the Saudis back in late 2014, took their hands off the steering wheel and let the market drive itself. The oil markets don't like that, that oil markets like to know that somebody out there has their hands on a steering wheel and that's part of what's going on now. So it's not just the supply and demand. Again, that's the primary thing, but this goes to my market psychology and just future expectations. Last but not least on the US, there are big legal questions. We have very tough antitrust rules, which prohibit US oil companies from working with each other to do anything. Aside from the questions of, should the US do something from a federal standpoint? Should just states do something? Can they do something? The question is, are they legally allowed to? These are all very big issues.

Josh King:

Sticking on the metaphor of the hands on the steering wheel. We're talking about the reduction, perhaps in people hitting the roads to commute to work or take vacation. We're talking about the captain's hands on the tiller a ship, less shipping traffic across the oceans. The captain at the stick of an aircraft, fewer aircraft in the air. What's been happening to the refined market over the past three months, as the demand for gasoline, jet fuel and other products has reduced so dramatically?

Mike Wittner:

We've been spending a lot of time talking about crude, but again, as far as the world, as far as end users in the world are concerned. Whether, they're consumers or businesses, nobody consumes crude oil. We consume products. Jet fuel, gasoline, diesel, shipping fuel, et cetera. Those prices have also been collapsing. I'll throw in one other little piece of jargon here. So in flat price terms, when I say flat price. It means okay, when you look at the screen or when you look at your newspaper, how much does it cost? Crude is around $30 a barrel. What's the price of gasoline, et cetera? You mentioned that earlier at the retail level.

Mike Wittner:

In the oil markets, the real measure of the strength or weakness of the product prices is, is what we call the crack, the gasoline crack, the diesel crack. And that's the difference between the price of that product, that refined product and the price of the crude oil that's used to make that product. So the crude oil price is usually lower and then it gets run through refinery and you get output of gasoline and other things. And the price of that product is higher. That difference between the high price product and a lower price crude, that's called the crack. Not only has the outright price of all these products fallen steeply in line with crude prices. The crack, the profit margin, if you will, of those product by product has also been under severe pressure.

Mike Wittner:

Just to give you an example, gasoline cracks in this country, on the ICE screen, they're typically, 15, $20 a barrel. Gasoline cracks are down to two dollars a barrel in the US and Europe. They were flirting with negative numbers recently, which never happened. Product prices, long story short, have been under severe downward pressure, just like crude. Even more severe downward pressure because the difference, those cracks are getting squeezed. That means refining margins as a whole for a refiner to process a full barrel. And they get all these products out. Their margins are horrible right now, and that's why they're buying less crude. There's too much crude out there and they're looking to put it in the storage. There's too much products out there. Product prices are also in contango, products are also being put in the storage. It's everywhere, it's across the board.

Josh King:

Well, as we wind our conversation down. Talk a little bit about the traders and the tools that they're using. The sectors that rely on massive quantities of crude and these refined products that you're just talking about are among the biggest participants in the futures markets, as both oil producers and consumers try to hedge their risk. ICE offers a number of products to assist in this. Do you see increased activity in any of them that suggests how investors and commercial participants are actually managing their risk?

Mike Wittner:

Most definitely, yes. There has been a big increase in activity. Both in the month of March and for the first quarter as a whole, for oil as a whole. So that's covering all of the crude and all of the products that trade on ICE. We have been setting records for daily trading volumes, average daily trading volumes for oil as a whole. Again, both in March and in the first quarter. If listeners are interested, we have press releases on our website with all those figures, but the bottom line is, sort of our flagship Brent crude oil contract has been very strong. And we obviously, do much more than just Brent. So different grades of crude oil, different locations of crude oil in North America have also been seeing very strong performance, very strong growth over that same timeframe.

Mike Wittner:

And for that matter, in recent years, there has been a lot of growth. That includes, for example, Permian shale oil being traded. That's WTI, Permian traded at Houston on the Gulf Coast. Just one example, that's been seeing very rapid growth. That really is a key price for exports from the US Gulf Coast. US crude gets exported around the world. We have products where you could trade the difference between Brent and WTI, that differential. That's important for traders managing their risk, hedging their risk on exports to Europe. The Brent WTI's differentials have been growing very strongly. Brent Dubai has been growing very strongly. That's on flows from Middle East to Asia. Again, this is a key risk management tool.

Mike Wittner:

So what I'm saying is not just Brent, but across the board, just giving you some highlights. Our trading volumes have been very strong and we're always working with customers and listening to customers about new tools that they need. New tools that the market is suggesting that they're going to need. And along those lines, for example, we're going to be starting up the Murban contract. That's crude produced in the UAE, in the Middle East. That's going to start up sometime this year. On the product side, which we just talked about. Again, very strong performance from the flagship product, which is ICE gas oil. And that's actually been seeing a boost from the move to a very low sulfur shipping fuel, which again, just two months ago, we thought that was going the big story for this year in the oil markets, how times have changed.

Mike Wittner:

That has happened and is in the process of still happening. And that's helped to boost activity from a hedging standpoint in gas oil. And we also have a whole suite of new products that were developed. The Marine fuel products, contracts for the new, very low sulfur shipping fuel, and those are also doing quite nicely, growing very strongly. So again, just a few examples. Pretty much strong across the board for Brent and other crudes. Pretty much strong across the board for gas oil, and Marine fuel and other products that we offer to the market.

Josh King:

At some point Mike, you're going to get back in your car and escape from Westchester. I'm going to drive south from the Catskills back to Manhattan, burn a few gallons of gas along the way. And we'll be able to meet once again and sort of take stock of, where the last few months has taken us. NYSE President Stacey Cunningham spoke at the Economic Club of New York recently about the importance of doing a postmortem of how the equity markets have functioned during this period of uncertainty. If you were to begin that postmortem of how the oil and futures markets have worked, what would you say?

Mike Wittner:

Well, I would say we are very happy with how the ICE oil markets have performed. I mean, as we talked about, we've had historic levels of price volatility, historically high levels of price volatility. Recently, we've had record trading volumes and the ICE oil market has performed very well. Things have gone very smoothly and there's simply been no significant issues. So we're really happy about that. That goes, by the way, both for our trading, but also for the clearing house, which is another important part of the business. The two go hand in hand, but the bottom line is, things have gone very smoothly. Customers are happy and we're happy. Look, this is what ICE was designed for from the beginning to have a highly functioning, all electronic energy markets, not just oil. Transparent and very reliable. And that's exactly what we've seen. Again, we have pretty high marks, more importantly, I think the market would give us pretty high marks, at this point.

Josh King:

We're still yet to see the outcome of both the OPEC Plus meetings today, the G20 meetings tomorrow. But as we wrap up our conversation, will the lower price environment end the short term oil production dominance of the US and give market share back to the Saudis and Middle East producers? I was talking with former treasury secretary Nick Brady a few days ago, and he postulated that a lead of an op-ed could be written that the US should actually increase its dependence on oil.

Mike Wittner:

That is definitely one of the changes, that we would expect. We had talked a little bit earlier about some of the changes that we could expect through changing behavior on the demand side, but on the supply again, the US shale sector has already changed a lot just in the last couple years. It's been more difficult for shale companies to get financing because banks, investors, want to see real return. They don't want to just see production for its own sake. That's something that's been building for a couple of years, but what we're seeing right now, is really going to accentuate that trend. We're seeing big cuts in spending and it is going to ... If the way things carry on the way almost everyone thinks, which is a lower price environment. We're not sure for how long, but a lower price environment means more caution on spending. Again, that's going to be a pretty big hit to US crude production.

Mike Wittner:

And even when crude production stabilizes and when spending comes back and output stabilizes and starts to grow again, it'll probably grow at a more conservative rate. Bottom line is, those barrels are always going to be in the ground. The question is, who's going to be doing is spending? Who's going to own those assets and whoever it is, it's quite possible that they're the larger oil companies, the major oil companies. There's probably going to be a shakeout. They'll be more conservative. They have a lot more financial muscle, but they take a longer term view. Yeah, I think that's a very reasonable expectation. And if that happens, yes, that does give market share back to the Middle East, to Saudi Arabia and the other Middle East players.

Mike Wittner:

That's really been the big thing in the oil markets in recent years is that, US oil production growth all by itself has met global oil demand growth. The US has been meeting global oil demand growth on its own. Again, this is what has the Russians and the Saudis kind of ticked off sometimes, when they think about it. They want some of that back. And I think that trend is going to give some back to them, provided that there's enough demand growth. So demand growth might also be in a lower trajectory, but if the US slows enough, the Middle East players will get something back.

Josh King:

Well Mike, you and I, and all of our listeners will continue to watch this triangle as it evolves. This has been a fascinating journey through the world of oil, as seen by one of the world's foremost experts. Mike Wittner, thanks so much for joining us today, Inside the ICE House.

Mike Wittner:

You're very welcome. This has been a lot of fun. So look forward to next time.

Josh King:

That's our conversation for this week. Our guest was Mike Wittner, head of oil market research for Intercontinental Exchange. If you like what you heard, please rate us on iTunes, so other folks know where to find us. And if you've got a comment or a question, you'd like one of our experts to tackle on a future show, email us at [email protected] or tweet at us, @ICEHousePodcast. Our show is produced by Rebecca Mitchell and Pete Asch, with production assistance from Ken Abel and Ian Wolff. I'm Josh King, your host signing off from the remote library of the New York Stock Exchange up here in the Catskills of New York state. Thanks for listening and we'll talk to you next week.

Speaker 1:

Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ICE, nor it's affiliates make any representations or warranties, express or implied as to the accuracy or completeness of the information and do not sponsor, approve or endorse any of the content herein. All of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell. A solicitation of an offer to buy any security or a recommendation of any security or trading practice. Some portions of the preceding conversation may have been edited for the purpose of length or clarity.

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Information contained in this podcast was obtained in part from publicly available sources, and not independently verified. Neither ICE nor its affiliates make any representations or warranties, express or implied, as to the accuracy or completeness of the information and do not sponsor, approve, or endorse any of the content herein, all of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell, a solicitation of an offer to buy any security, or a recommendation of any security or trading practice.