Finforall

26.06.2020

Oil Crisis

With rising diesel and petrol prices in the country, many of you may have forgotten the crisis that had gripped oil markets in a time not so long ago. Just to refresh your memory, on 20th April, WTI futures (to be delivered in May) actually went negative. Yes, it somehow cost more to get oil off your hands than to buy it. Surprising? Actually, it really wasn’t. But before we dive into the reasons behind this spectacular sell-off, we need to discuss…..

WTI? Brent? Wait, don’t you mean oil?

First and foremost, it was WTI futures which actually traded negative on the aforementioned date. But you must be thinking that Brent is the benchmark for crude. Well, that is true. Brent is an international benchmark price used by OPEC (Organization of Petroleum Exporting Countries, a cartel that produces most of the global oil supply), and is an average of prices of oil extracted from fields in the North Sea in Europe. West Texas Intermediate (WTI) crude, on the other hand, is a benchmark for oil prices in the United States (which became the world’s largest producer after the advent of shale drilling). Both differ in other factors, such as their sweetness and sulfur content. But a major distinction, in addition to the location of drilling, is that the cost of transportation for Brent is significantly lower as compared to WTI crude. This is simply because Brent is drilled from areas near the sea, while WTI is produced in landlocked areas, thereby increasing storage and handling costs. Capeesh? So let’s move on to…

What determines oil prices?

Oil, like any other good or service, is priced by market forces of supply and demand. Like other commodities, oil has storage and transportation costs associated with it too. In times of excess supply or low demand, oil prices take a severe beating (this is largely what happened, but more on this later). And if production is tightened in an environment of rising demand, oil prices will shoot up sharply. However, since demand for oil will always exist, as it powers airplanes, cars, trucks, ships, factories etc., an oil producer should have incentive to keep production low to kick up prices. But, oil is produced by a number of countries, and any reduction in supply made by you can be fulfilled by another country. So naturally, it makes sense for these oil producing nations to enter into an agreement to synchronize their production to fix prices, which resulted in the birth of OPEC, headed by its de facto leader Saudi Arabia.

Friends turned enemies

In early March, there was a severe row in OPEC+, the alliance between OPEC and Russia, another major producer. Largely, it was a disagreement on proposed production cuts between Russia and the rest of the group, and resulted in the breakdown of the alliance. Following this, the 2nd and 3rd largest oil producing nations, Saudi Arabia and Russia respectively, engaged in a price war which severely damaged oil prices. It is important to note that oil prices had already been depressed since the beginning of the year, due to the fall in demand from the world’s largest consumer, China, which was struggling to contain COVID-19 and had shut down most of its businesses. So, demand was already low, and then a price war resulted in an oversupply, thereby causing a double whammy to oil prices. Eventually, the United States mediated a large-scale production cut which the OPEC+ alliance eventually agreed upon, but these were not to be enforced until at least the following month.

So, to summarize, demand for oil had cratered, as the COVID virus spread across more parts of the world, wreaking havoc in Italy, Spain and the US in particular. At the same time, Russia and Saudi Arabia had flooded the market with barrels of oil. The only thing that had held still were the storage and transportation costs. But then….

The day the world changed

The day I am referring to is 20th April, 2020. It was a key date in the oil futures market, since the prices for the oil to be delivered in May via these futures was to be set on 21st April. In normal conditions, most contracts trade in a narrow band close to maturity as no one wants to be stuck in a situation where they have to deliver more oil than they can handle or take delivery of more oil than they can store. The participants range from refiners and commodity traders (who are probably comfortable with taking delivery or delivering oil) to banks and funds (who are definitely not in the business of storing or handling oil). In most cases, they rollover contracts (close out the current position in the near-term contract and take the same position in the next one). But oil demand would recover eventually, and with production cuts on the way, why not buy cheap oil today and store it for sale at a later date?

Now, with a lot of oil lying around, storage costs were obviously the next in line to shoot up. As more oil (due to excess supply) needs storage (it is useless since there is no demand), the number of storage places start to shrink. As mentioned earlier, this problem is not that severe in Brent, as it can be stored in oil tankers which remain at sea. But since WTI is produced at landlocked areas, and oil can only be stored in special places (Cushing, Oklahoma), storage spaces started running out. And the traders who became aware of this on 20th April realized that, unless they sold their futures positions, they would be stuck with a barrel of oil which could be stored nowhere. Thus, the sell-off began, and it became a full-blown sellers’ market with no buyers for oil, resulting in the collapse of the WTI futures price to as low as -$40. And the idea of buying cheap oil today and storing it for when demand recovered evaporated into thin air as storage costs shot through the roof.

So, excess supply, non-existent demand, and a sharp increase in storage costs meant only one thing: the world witnessed, for the first time ever, negative oil prices (note that Brent remained above $20, only WTI traded negative). Exchanges were forced to go back to the drawing board to be able to incorporate negative prices in their commodities, and the world’s largest commodity ETFs had to refigure their investment strategies. Trading apps which allowed users to gain exposure to commodities also had to tweak their apps, as many of them were not programmed to reflect negative prices on their screens. And the world was changed forever.

Sharing is Caring