To paraphrase former US president Franklin Roosevelt’s 8 December 1941 speech, following the Pearl Harbor attack, yesterday (20 April 2020) was “a date which will live in infamy” as the United States of America was suddenly, and perhaps deliberately, attacked by negative oil prices.
Suddenly, because people expected a barrel to trade at $3 and not minus $37.63, and deliberately because the world is still making sense of the virus unleashed by China that throws a new surprise with every new day.
Not that the oil markets were having a ball before 20 April, but what happened yesterday in the oil markets was as unprecedented as the outbreak of the coronavirus (Covid-19) within the US, the possibility of which was dismissed with utmost prejudice in January.
So, how did the price of crude go from trading at $17.85 a barrel to minus $37.63?
Hold On, What Is This WTI Everyone Is Talking About?
Firstly, one must note that only one of the three benchmarks was trading negative last night. A benchmark crude serves as a reference price for buyers and sellers of crude oil across the world. While Western Texas Intermediate (WTI), the one trading in the negative, happens to be one, the other two are Brent Blend and Dubai Crude.
WTI crude is sourced primarily from Texas, is one of the highest quality oils in the world, is easy to refine, and is the main oil benchmark for North America.
Produced in Texas, the crude travels through a complex network of pipelines to the Midwest and the Gulf of Mexico, where it is refined. Thus, in a way, these pipelines also served as one of the storage options for WTI crude. The final delivery and price settlement happens in Cushing, Oklahoma.
While storage capacities in Cushing are landlocked, thus making the shipping of excess crude difficult, Brent is more seaborne, thus enabling the storage of excess crude on oil tankers.
Great, Can I Head To The Nearest Petrol Pump And Get Paid For It?
No, for three reasons.
First, it’s a lockdown, and thus you shall encounter trouble with the police.
Two, you do not pay for the crude, but for the final refined petroleum product. Therefore, this is a cost to transportation, storage, refining, and then again transportation to the gas station that must be factored into the equation.
Three, WTI does not serve as the global benchmark for oil prices. Brent Crude, which was trading in excess of $20 a barrel yesterday, serves as the benchmark for two-thirds of oil contracts globally.
Moreover, the government of India looks at the average of Oman, Dubai and Brent crude, which was trading at $20.56 a barrel on 17 April.
Sigh! Hey, There Was A Line Or Two About Oil Futures Contracts As Well
That is the only line one must care about if one is to make sense of what happened last night.
Given a barrel of oil is close to 160 litres, it becomes a little inconvenient for traders to physically trade the commodity. This is where the oil futures contract comes into play.
A futures contract, in this context, is a legal agreement to buy or sell crude at a predetermined price at a specified time in the future. These contracts are standardised for quality and quantity to enable trading in markets. The buyer of the commodity, in this case, oil, commits to buying and takes delivery of the barrels when the futures contract expires.
For oil, the contract size is a thousand barrels, and the last trading day for any contract is the third business day before the 25th calendar day of the month, or in this case, 21 April (today).
Now, given the nature of oil and its vulnerability to geopolitical tensions, traders deal in oil futures contracts to make a quick buck by buying it at lower prices and selling it in a profitable deal before the contract expires.
This is where it all went haywire last night.
Given the contracts for deliveries in May were to expire on 21 April, traders were under tremendous pressure to offload their trades, given most of them were in no position to undertake physical deliveries of the barrels.
Also missing in action were players who undertake these physical deliveries to refine crude into a finished product like jet fuel, petrol, and so forth. This was due to the lockdown which has literally annihilated the demand for fuel as cars are halted and planes are grounded.
In an ideal scenario, there are buyers and sellers, but yesterday, the sellers outnumbered the buyers. Therefore, oil that was selling at $17.85 in the first hour eventually went into negative. Thus, from selling a barrel at $15, traders were giving away as much as $35 for someone willing to take physical deliveries for the barrels off their hands.
However, the negative pricing was only for the May contract that expires today (21 April). At the time of this explainer going to publishing, future oil contracts for June are trading at more than $20 while for September they are as high as $30.
Hold On, Don’t We See Such Price Dive Each Month, So Why Now?
Usually, the difference between trading prices between contracts is a few cents, here and there, given the market is moving and for every trader, there is a willing buyer of tangible crude. However, what occurred yesterday was an anomaly, for four reasons.
First, the lockdown, that dented the demand for crude for refining.
Two, the price war between Russia and Saudi Arabia resulted in OPEC members and other oil producing countries being unable to reach a truce in terms of oil output.
The war that began in early March when Russia refused to cut down oil output led to both Saudi Arabia and Russia flooding the oil market. Clearly, the oil war did not factor in the lockdowns in the US or the West.
Thus, the flooding of the oil market further depressed prices for oil globally. Though the two nations tried to cover up with a deal earlier this month (explained here), it was too little too late, and its impact will only show up in the coming months.
Three, and most importantly, the lack of storage space. As elaborated here, the world was already running out of storage space for oil last month.
The consequences of exhausting storage space were hurting the small producers in the United States as well. Wyoming Asphalt Sour, a dense oil used to make paving bitumen, was being sold at negative prices in March. Thus, producers were actually paying the buyers to get rid of the oil.
There were also reports of traders looking to buy storage spaces on oil tankers, and some choosing to park in complex pipeline networks.
Also, to put things into perspective, the crude stockpiles in Cushing, Oklahoma, were at 55 million barrels since the end of February with the place having a storage capacity of only 76 million barrels.
Lastly, an understated factor was at play here. As per some media reports, the price of the WTI was being supported by the United States Oil Fund, an exchange-traded fund that owned close to 25 per cent of the May contracts. These contracts were bought on behalf of the investors who were anticipating a rebound in the price of oil.
However, as the price dive began on Monday (20 April), this fund started dumping its holdings, replacing it with June and July contracts, and adding to the seller count.
If Prices Are Negative, Why Not Simply Turn The Oil Tap Off Until Demand Resumes?
For two simple reasons.
One, what occurred yesterday was an anomaly and as nations begin to lift lockdown, starting with China, demand for fuel, led by road transportation and aviation will return. While some small-scale producers will indeed ‘run out of fuel’, for the big producers, it’s cheaper to simply keep the output going.
Two, it’s far cheaper, even at minus $37.63, to keep the output going instead of simply shutting down the production unit. For instance, shutting down oil wells to come with a high economic cost and in some cases, renders them permanently damaged for the future.
So, What’s Next?
Firstly, in the larger scheme of things, the attention will now move to June contracts. While the WTI traded above zero by the time markets closed, what was witnessed last night will serve as a cruel reminder for oil markets for years.
Two, with economies looking to reopen, the probability of such a negative price dive is less. The OPEC+ deal brokered by the US between the member nations will lead to an oil output reduction of 9.7 million barrels.
Even if this reduction fails to keep up with the overall demand which could be in the neighbourhood of 20 million barrels a day, globally, the chances of a negative price this as gruesome as this are little.
Assuming the lockdown globally extends into July (a wild, wild assumption), the producers will have to start looking at shutting shop for negative prices work only as an anomaly, and not as a routine.
Thus, while it may take a while for demand to hit the pre-Covid-19 level again, the $58 mark at which WTI was trading in January is a long shot from here.
The US can look for as many storage spaces as it likes, but only a moving economy will put crude out of its pricing misery, the only hiccup being no one knows when the economy will move again.
As Professor Hulk says in Endgame, these are confusing times.
Tushar Gupta is a senior sub-editor at Swarajya. He tweets at @tushjain15.