Permian Basin shale oil drillers staring down the worst bust in a generation now face a once-unimaginable threat — there could soon be no place to put their crude.

"The only thing [producers] can do is try to sell their oil at $5 to $10 per barrel in West Texas or shut their wells in and hope that they can open them back up when the price is higher," Kirk Edwards, the CEO of Odessa, Texas-based Latigo Petroleum, said in an interview. "Everything is coming to a screeching halt in the Permian on the drilling side too. The question everyone is having to ask themselves is: Why in the world would you drill a well at these prices? And the well you are currently drilling — why would you complete it?"

Concerns are mounting that the U.S. soon may not have enough oil storage to absorb a collapse in demand caused by the coronavirus that has started to ripple through the supply chain, with consequences for producers, pipelines, refiners and consumers.

Oil market experts do not expect international prices to move into negative territory, but they said an overflowing storage situation could shut down pipelines, shut in wells and destroy billions of dollars in value that would take years to recover.

At the heart of the problem is evaporating transportation fuel demand. People across the world are sheltering in place at the same time that Russia and Saudi Arabia have launched an oil price war and are increasing supply into an oversaturated market.

"In our base case, transport fuel demand could fall as much as 70% in affected regions. Further, a recession would follow over the rest of the year even as containment measures ease for 2H'20," Citi Global Head of Commodities research Ed Morse said during a March 31 webinar. With global oil demand averaging nearly 100 million barrels per day in 2019, Morse projected a worst-case scenario of 20% of that demand drying up in the second quarter.

Oil market expert and former BP statistical modeler Mark Finley envisioned a similar drop. Finley told S&P Global Market Intelligence that even if Russia and Saudi Arabia agree to cut back production, the lack of demand could still overwhelm global storage.

"We're looking at potentially a 20% decline in worldwide oil demand in two to three months. Both the size and the pace are without precedent," said Finley, a fellow in energy and global oil at Rice University's Baker Institute for public policy. "If storage fills, there's another shoe to drop on the price of oil. Because when that happens, then it's not the economics of storage that sets the price, it's the economics of stopping somebody from producing a barrel of oil."

The largest decline of demand on record had been a 10% drop from the start of the global oil crisis in 1979 to 1982.

Negative prices and shut-ins

Finley led BP PLC's production of its Statistical Review of World Energy and the oil major's analysis of the oil market until his retirement from the company about a year ago. He said because of the logistical constraints of filling storage, "there's a lot of buzz out there about prices going negative."

Even though some price points for distressed crudes, like Western Canadian crude from the country's oil sands region or oil from the U.S. Midcontinent, are in the single digits and could move negative, he does not foresee the U.S. benchmark or international benchmark hitting zero and staying there. Goldman Sachs oil analysts agreed.

"Waterborne crudes like Brent will be far more insulated, staying near cash costs of $20/bbl with temporary spikes below," they wrote in a March 30 report. "Shut-ins will not be based upon where wells sit on the cost curve but rather on logistics and access. High-cost waterborne crude oil that can reach a ship (storage we have historically never run out of), are better positioned than landlocked pipeline crude oil sitting behind thousands of miles of pipe, like the crude oils in the U.S., Russia and Canada."

Producers that find themselves far from export options with local storage full will likely have to resort to shut-ins. Morse estimated that short-term global supply curtailments could reach more than 10 million bbl/d in April, and Goldman Sachs said these shut-ins could reduce the global upstream sector's oil supply capacity by up to 5 million bbl/d.

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Negative spot prices would be driven by these landlocked producers that fear reservoir damage from shut-ins. But any significant shut-ins could set the stage for violent price increases when demand recovers.

"This will likely be a game-changer for the industry," the Goldman analysts said. "Once you damage the capital stock in oil it is an expensive and time-consuming process to rebuild, assuming it can be rebuilt at all."

Finley and the Goldman Sachs analysts noted that logistical bottlenecks of filling storage are already becoming apparent even as spare capacity remains. "What the futures market is telling us is that we have a [storage] problem right now," Finley said. "The steepness of the contango in the forward prices is now bigger than it was in the depths of the financial crisis."

On Dec. 19, 2008, when oil prices bottomed during the 2008 financial crisis, WTI oil prices for delivery one year into the future were at a roughly 65% premium to the nearby month price. On March 31 of this year, they were at a more than 75% premium. By contrast, on Jan. 6, when the market was concerned about the supply-side ramifications of an escalating conflict between the U.S. and Iran, oil prices for delivery one year out were trading at a nearly 10% discount to the nearby-month price.

Contango, or forward premiums, are the market's way of saying "I will pay you to store this oil," Finley said. "The conventional last resort is to take oil tankers and convert them from a transport vehicle to a storage platform. The economics of floating storage is typically the oil market's canary in the coal mine. And we seem to be there."

How soon is now?

Nobody knows exactly how much remaining storage capacity there is, leading analysts, experts and traders to estimate the oversupply situation. To try to better understand market dynamics, U.S. Sen. Lisa Murkowski, R-Alaska, sent a letter to the head of the U.S. Energy Information Administration asking that the agency "prioritize the collection and analysis of data related to petroleum storage."

"Producers will continue to produce, filling up all kinds of tanks and tankers, until capacity is released," she wrote. "Available petroleum storage can serve as a gauge of the potential for shut-in production, providing us some measure of both imminence and severity."

Record commercial crude oil storage in the U.S. peaked at 535.5 million barrels in March 2017. In the week to March 27, U.S. government data showed the second-largest ever build in stockpiles at 13.8 million barrels, putting inventories 66.4 million barrels below the record.

There may be some extra storage cushion available to the market. A September 2019 report from the EIA pegged U.S. commercial crude oil storage capacity at 599.6 million barrels. The federal government's strategic petroleum reserve, which held 635.0 million barrels as of March 27, has enough capacity to hold another 78.5 million barrels. Although President Donald Trump ordered the U.S. secretary of energy to top off the reserve, Congress has not yet authorized the crude purchases to enable that policy.

The near-record storage builds the U.S. saw at the end of March "are just the start," Enervus analysts wrote in an April 1 note. "As refiners cut rates to operational minimums and begin to idle capacity, even more barrels are going to head into storage over the coming weeks. … Up to 6 million bbl/d of light sweet crude is at risk of becoming stranded in April if refinery utilization rates are cut to 50%. Most of those barrels are in the Permian, Bakken and Eagle Ford."

Because gasoline demand has fallen, the margins from producing it recently hit negative levels, leading oil refiners to cut the amount of crude oil they process into petroleum products each day.

"If you think there's an extra 3, 4 or 5 million barrels per day piling into the system … you run out of [storage] pretty quickly," Finley said.

Where is there space?

There are some potential options for offshore crude storage to help fill the gap.

Morningstar Inc. director of energy commodities research Sandy Fielden noted that Buckeye Partners LP's Buckeye Bahamas Hub south of Florida has some spare capacity, though it is unclear whether it is contracted. The Louisiana Offshore Oil Port owned by MPLX LP subsidiary Marathon Pipe Line LLC, Shell Oil Co. and Valero Terminaling and Distribution Company, he added, has a salt dome cavern specifically for WTI Midland crude that may also have spare capacity.

The Port of Corpus Christi can also step in to help, according to CEO Sean Strawbridge, who said in an email that the port can support floating storage in addition to the 15 to 20 million barrels of new storage coming online from Moda Midstream LLC, Buckeye, Epic Midstream LLC, Pin Oak Energy Partners LLC, Flint Hills Resources LLC and others.

Offshore storage, however, cannot make enough of a difference to resolve what ultimately happens onshore.

"I think we're going to see storage problems regardless," Fielden said. "It seems to be that extensive demand destruction is enough that basically even if we fill up the storage in an orderly fashion as it were, there still isn't enough."

Some pipeline operators, meanwhile, are coming up with their own solutions. Gray Oak Pipeline LLC, a joint venture between Marathon Petroleum Corp., Enbridge Inc. and Phillips 66 Partners LP notified the Federal Energy Regulatory Commission on April 3 that the crude pipeline system will offer temporary storage for its shippers in "response to fast-developing market conditions."

Glut could cause conflict between pipelines, shippers

The CEOs of Parsley Energy Inc. and Pioneer Natural Resources Co., both of which hold significant positions in the Permian Basin, on March 30 asked Texas oil and gas regulators to hold a hearing on the subject of setting production limits as one means to avoid overfilling storage.

"The causes and consequences of the oil market collapse enveloping Texas compel prompt commission action," Pioneer CEO Scott Sheffield and Parsley CEO Matt Gallagher wrote. "Oil purchasers and marketers … have advised our companies that oil storage availability in May will be limited and producers should reduce oil production."

The crisis has significant implications for the pipelines and their customers, which according to Holland & Knight LLP attorney Seth Belzley could lead to contract disputes by way of declaring force majeure. He said in an interview that while he expects pipeline shippers to invoke that legal provision to get out of take-or-pay agreements if refiners are forced to shut down, the strategy may not prove successful.

"It's generally not going to be considered a force majeure because … it's understood that the shipper's obligation under that contract is either to use the shipping capacity or just to pay the minimum fees that are due," Belzley noted. "I've personally been involved in several cases where … the shippers will declare a force majeure to try and avoid their take-or-pay obligations, and that at least puts them in a position to negotiate or litigate."

Plains All American Pipeline LP Executive Vice President and CFO Al Swanson said during a March 30 conference call facilitated by BMO Capital Markets that he is not concerned about force majeure, in part because a customer would still have to pay the pipeline operator.

"It's contractually negotiated individually. … There's not a 'standard' language," he said. "Force majeure for [COVID-19] likely if it was to come up will be hopefully short-lived, a month or two months. … We're not aware of any force majeure notices from shippers at this point."

Pipeline shippers could, however, see some financial relief if infrastructure operators themselves declare force majeure because of clogged pipes.

"At that point if a … shipper brings a barrel to the receipt point, the pipeline would be in a position of having to say, 'I can't take it' … and that would alleviate the shipper from paying the pipeline," Belzley said.

On the ground in West Texas

For Latigo Petroleum's Edwards, the situation has upended his business philosophy. Like the CEOs of Pioneer and Parsley, the prominent local oilman said he has come to support intervention from the Texas Railroad Commission. The agency has not prorated oil production in decades.

U.S. production cuts probably would not be enough, Edwards said. He wants the Trump administration to slap tariffs on imports of foreign crude if Saudi and Russia will not stop unloading crude into the world market.

For veteran Midland-based oilman Kyle McGraw, the glut means he has had to spend much of his time the last few days working out how much production to shut in on the property he bought from Apache Corp. in late February. The 100-well field was much smaller than he the ones he oversaw as an executive at Legacy Reserves, a debt-laden MLP that went through bankruptcy in 2019. But the asset seemed like a solid project to run with his two sons under their family-run company, Trinidad Energy, following his retirement.

Oil tanked in the month since Trinidad Energy closed on the deal, and in Midland, career oilmen now face the worst oil bust that any of them has ever seen. McGraw thought it was bad, and then he got a call from the consultant who markets his oil production.

"'You better get ready'," McGraw recounted her saying. "'Storage is filling up fast. Cushing is running out of room. The Gulf Coast is full. The Permian is full. We may have some Permian producers, during the month of May, who will not be able to sell their oil at any price. Which has never happened in history."

As the chairman of the Permian Basin Petroleum Association, McGraw said he has not yet heard of companies shutting in production because they had no place to sell their oil. But he does know about the letters some oil companies have received from shippers asking them not to bring on new volumes unless they are tied to a customer.

"It's a looming crisis that hasn’t quite hit," McGraw said.