The news which fancied our mind in the last week was:
“Crude oil price plunges below zero for first time in unprecedented wipe-out”
– Economic Times on 22nd April, 2020.
While reading this article, it might sound confusing for a reader and it might seem that one can get oil freely simultaneously with a cash back from the oil company, which is not true.
First and foremost, we need to understand here is that – this is not “oil price” they are referring to, its “crude oil price”. And the ‘price’ which we are discussing here is not the price for the consumer or transaction price, these are “Future Price” of a contract, crude oil being an underlying asset.
For understanding this, we need to familiarise ourselves with few terms:
- Future Contract: A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. In this particular case, the underlying asset was “Crude Oil”.
- Crude Oil: It is the non-refined oil which is extracted directly from the sea or wells is called the crude oil. This crude oil is of no use without refining.
- Barrel: We often see in the newspaper, that the oil prices per barrel has increased or decreased by so much. So Crude oil is measured in ‘barrels’ and a barrel contains 159 litres of oil.
- Operation of Crude Oil Market in the World and Oil Benchmark Price?
We can extract crude oil by two sources: one from land or wells and the other from sea. Wherever the oil fields are there in the World, the quality of crude oil extracted from each region is different. Some have more sulphur and some are more flammable.
The crude oil which is extracted from the sea gets transported to the buyers by ships and the one which is extracted from the wells (like America), they are supplied through pipelines or trucks which is quite expensive.
The oil traders always calculate which is the suitable region to buy crude oil at a cheaper price.
A benchmark price of crude oil is decided after considering many factors like; oil quality, oil quantity, and transport facility or cost like LME (London Metal Exchange) we have for metals. The trader or importing country takes the final decision to buy the crude oil on the basis of the benchmark price.
There are 2 main crude oil benchmark prices used by USA:
1.Brent crude oil Benchmark
Crude oil extracted from the North Sea near Norway and the United Kingdom is sold at the Brent crude oil Benchmark price. Crude oil of this region contains a high percentage of sulphur which is good to extract diesel of good quality. Two-thirds of the world’s crude contracts are signed in this Brent crude oil benchmark price.
Future contracts of the Brent crude are mainly traded on the Intercontinental Exchange (ICE), London.
2. WTI Benchmark
Oil of this benchmark is extracted from American oil wells. It is transported through a pipeline and stored in Oklahoma, USA. It is used to make low-sulphur gasoline and low-sulphur diesel. It is lighter due to its lower API gravity and sweeter due to lower sulphur.
WTI futures contracts are traded on the New York Mercantile Exchange (NYMEX). In these exchanges, there are two types of people who buy and sell future contracts in the market. One lot are those who actually need oil for further refinement and sell and the other lot are intermediaries who make money out of price fluctuations.
What happened on April 21, 2020?
Usually, a NYMEX futures contract provides a price per barrel for 1,000 barrels of oil to be delivered to a massive oil logistics hub in Cushing of Oklahoma City (storage place in USA) over the course of a specific month.
Future Contracts are sold by oil producers to lock-in prices for future production and bought by refiners and storage entities to lock in prices for purchases. And these also sold and bought by oil traders to mediate prices between buyers and sellers, providing market liquidity.
When you hold a contract at its expiration, you have an obligation to make that actual delivery to the buyer at Cushing. Normally, when contracts expire traders sell their contracts to demand sources that can take actual delivery, like refiners or oil storage, with minimal impacts on prices.
April 21, 2020 (Tuesday) was the last day of trading for the WTI crude oil futures contract for May—all the oil traded under this contract is set to be physically delivered next month. What has happened this month is there appears to be no buyers for the May contract, which expires on April 21. Technically, when there will be no buyers, the future prices should be zero. Prices collapsed because of the following two major factors:
1.Demand plummeted: While the country is still on lockdown and demand for fuel is still at rock-bottom. As global demand for crude oil (which is used to make gasoline and jet fuel) has plummeted.
2.Storage Capacity Exhausted: The United States has already seen its oil storage capacity filled up because airlines and other buyers aren’t using nearly as much crude as they were before the crisis. With no storage capacity, those firms with the ability to store oil (like refineries and airlines) aren’t buying it anymore.
But we were told that the futures prices nose-dived and plunged below zero for the first time. Prices collapsed from about $18/barrel on April 17 to -$37.63/barrel. The negative $37.63 per barrel—mean that companies must now pay a buyer to take oil off their hands and store it if they want to exit the market. It means the crude oil seller was paying US$ 37.63 (incentivise) to the buyer for every barrel purchase. In energy markets, where physical systems of the oil production facilities cannot be easily shut off, prices can go negative to incentivize suppliers to avoid cease of production.
If traders were unable to find storage for oil deliveries next month (even at a much lower negative price), the situation is going to be worse. Unless oil demand returns quickly, prices are likely to collapse again in order to drive oil producers to turn off production (which is called “shut-ins”) reducing production can be costly and can damage oil wells.
Similarly, production much greater than demand could overwhelm oil storage globally and cause oil prices to reach unprecedented low levels throughout the world. Already, Canada is seeing oil prices consistently near or below $0/barrel. Many oil-exporting nations depend on oil exports to drive their economy and are likely to suffer economic crisis.
Good news is that most oil set to be delivered to Cushing next month settled at prices well above $20/barrel. Prices for June and July contracts remain above $20/barrel, as do prices for international oil future contract deliveries. Nevertheless, the signs for oil markets are not looking good in near future.