OIL PRICE CRASHES

OIL PRICE CRASH

Everyone would agree that Crude oil is almost an essential commodity in modern times. But many couldn't believe that crude oil could sell at negative rate. Well to explain what happened ? how it happened? i am writing this blog. In fact, there have been instances of commodities being sold at negative prices. For instance, bonds have been known to have negative yield, in which a bondholder makes a loss by lending money. First,lets look at how is oil priced.

How is oil priced?

The first thing to understand is that, even before the COVID-19 outbreak induced lockdowns across the world, crude oil prices had been falling over the past few months. They were close to $60 a barrel at the start of 2020 and, by March-end, they were closer to $20 a barrel.

The reason was straightforward: Too much supply and too little demand .

Oil prices are controlled by traders who bid on oil futures contracts in the commodities market. That's why oil prices change daily. It all depends on how trading went that day. Other entities can only affect the traders' bidding decisions. These influencers include the U.S. government and the Organization of Petroleum Exporting Countries. They don't control the prices because traders actually set them in the markets.

*What are oil future contracts? The oil futures contracts are agreements to buy or sell oil at a specific date in the future for an agreed-upon price. They are executed on the floor of a commodity exchange by traders who are registered with the Commodities Futures Trading Commission(CFTC). Commodities have been traded for more than 100 years. The CFTC has regulated them since the 1920s.

The first futures contracts on crude oil were traded in 1983, with the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (Nymex).

Crude oil prices are primarily determined by something called commodities futures. Investors look at the factors that may affect the value of oil and decide at what price they will buy or sell oil in the future. There are usually three main factors that investors look at when trading futures to help them determine what crude oil price they are willing to pay. 

• How much oil is available in storage, 
• the current output of oil, and 
• the expected demand for gas and oil .

Commodities traders fall into two categories. Most are representatives of companies who actually use oil. They buy oil for delivery at a future date at the fixed price. That way, they know the price of the oil, can plan for it financially, and so reduce or hedge the risk to their corporations. Traders in the second category are actual speculators. Their only motive is to make money from changes in the price of oil.

The picture depicts the global benchmarks used worldwide for crude oil.

.The Organization of Petroleum Exporting Countries (OPEC) is a group made up of the 12 highest oil producing countries in the world. Between them, these countries control about two-thirds of the world's petroleum. This organization is responsible for almost half of the world's oil exports. OPEC works to make sure that the supply at any given time is limited enough to keep the price of oil from dropping.

In the recent past, the OPEC has been working with Russia, as OPEC+, to fix the global prices and supply.

OPEC is not the only factor that affects crude oil price today. When the economy is sluggish and inflation is high, however, this drives the cost of most goods like food higher. People tend to spend less on gas and save more money instead. This drops the demand for oil, which generally causes prices to fall.

The economy can affect the price of commodities like oil in other ways besides basic supply and demand. When the commodity trading investors look at factors like the global economy and politics to try to guess what crude oil prices will be, their decisions can have a huge effect on the price. Crude oil prices can change drastically every day depending on what happens politically and economically around the world. Investors adjust the amounts they'll invest by watching current events and trends. The weakness or strength of the US dollar against other global currencies can also change the cost of oil quickly.

Where did the trouble start?

In early March, this happy accord came to an end as Saudi Arabia and Russia disagreed over the production cuts required to keep prices stable. As a result, it started oil price war amongst oil-exporting countries, led by Saudi Arabia, started undercutting each other on price .This was an unsustainable strategy under normal circumstances but what made it even more calamitous was the growing spread of novel coronavirus disease, which, in turn, was sharply reducing economic activity and the demand for oil.  It must be understood that cutting production or completely shutting down an oil well is a difficult decision, because restarting it is both immensely costly and cumbersome. Moreover, if one country cuts production, it risks losing market share if others do not follow suit. Coronavirus worsened the situation beyond imagination, reducing oil demand substantially, thereby making oil almost worthless.

By the time the discord between Saudi Arabia and Russia was sorted out last week, under pressure from US President Donald Trump making Saudi give up first, it was possibly too late . On April 9^th 2020 OPEC countries & Russia decided to cut production by 10 million barrels a day — the highest production cuts — and yet the demand for oil was shrinking faster.

This meant that the supply-demand mismatch continued to worsen right through March and April. According to reports, the mismatch resulted in almost all storage capacity being exhausted. Trains and ships, which were typically used to transport oil, too, were used up just for storing oil.

What happened on 20^thApril,2020(Monday)?

The May contracts for WTI, the American crude oil variant, were due to expire on Tuesday, April 21. As the deadline approached, prices started plummeting. This was for two broad reasons.

By Monday, there were many oil producers who wanted to get rid of their oil even at unbelievably low prices rather than choose the other option — shutting production, which would have been costlier to restart when compared to the marginal loss on May sales.

From the consumer side, that is those holding these contracts, it was an equally big headache. Contract holders wanted to get wriggle out of the compulsion to buy more oil as they realised, quite late in hindsight, that there was no space to store the oil if they were to take the delivery.

The USO (United States Oil Fund) - an ETF for crude, held 25 percent of the outstanding shares of May 2020 WTI oil futures. But that contract will end tomorrow.

Buyers of these contracts must either sell these contracts for oil now or take physical delivery of the oil at the end of May. Of course, an ETF like the USO who deals in paper barrels is not eager to take physical delivery of any amount of oil - even if they could find somewhere to store it.

The result? They must dump their oil, and they must do it now, no matter what the price.

They figured that it would be more costly for them to accept the oil delivery, pay for its transportation and then pay for storing it (possibly for a longish period, given the circumstances) especially when there was no storage available, than to simply take a hit on the contract price.

This desperation from both sides — buyers and sellers — to get rid of oil meant the WTI oil contract prices not only plummeted to zero but also went deep into the negative territory. In the short term, for both the holders of the delivery contract and the oil producers, it was less costly to pay $40 a barrel and get rid of the oil instead of storing it (from buyer’s point of view) or stopping production (from producer’s point of view). WTI crude oil futures settled at -$37.63 per barrel on Monday, down by $55.90 on the day. Not only was it the largest price drop for the commodity in history at some 305.97 %, but it was also the first time that the WTI futures market fell below $0.

·        The decline reflects the logistical limits of the physical oil market. 

·        The sharp drop into negative territory for oil futures was brought about by more than “just” storage limits and overproduction. It’s about the timing of future contracts.

 How will this impact India?

The Indian crude oil basket does not comprise WTI — it only has Brent and oil from some of the Gulf countries — so there is no direct impact. But oil is traded globally and weakness in WTI is mirrored in the falling prices of the Indian basket as well.

There are two ways in which this lower price can help India. If the government passes on the lower prices to consumers, then, whenever the economic recovery starts in India, individual consumption will be boosted. If, on the other hand, governments (both at the Centre and the states) decide to levy higher taxes on oil, it can boost government revenues.So it is bit of a dilemma whether to shift the balance in favor of individual savings or in favor of government revenues.

Although I would suggest  that GOI for now keeps this balance tilted in favor of individual savings so that consumers would have more buying power at their disposal.

 

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