Understanding the Negative Oil Prices During Covid Pandemic by Rajat Jhingan

Why in News?

• On 22nd April 2020, crude oil prices took the fall below zero. This was something to happen first time in human history, no precedence ever. When we talk about negative prices, we mean that buyers are being getting paid by the sellers to buy the oil. This was happening because the futures for WTI i.e.  West Texas Intermediate  (US Crude) reached minus $ 37.63 per barrel. So, to avoid incurring the storage cost, the sellers were inducing the buyers, since the global demand for the oil crashed. l to minus $37.63 a barrel level.
• This phenomenon of negative pricing can happen again, as is claimed by many analysts around the world.

Background

• Global travel restrictions and lockdowns due to the coronavirus pandemic has made the demand for oil to crash.  But the major oil producers were unable to reduce their output in the same proportion. The subsequent oil overabundance is stressing transportation and capacity limit in the US
• The main US benchmark for crude oil is West Texas Intermediate (WTI) crude oil price. It fell to its lowest in trading in four decades touching minus $37.63 a barrel
• As global economy is pauses, there are no purchasers of the crude oil. As we know the demand supply principle kicked in. U.S. capacity reached its maximum point and it has nowhere to put its surplus oil which was being extracted. Thus resulting in the fall below zero.
• In negative pricing, it’s the manufacturers who are paying traders to purchase the oil. It happens when the selling cost falls below the production and transportation cost.
• As the storage space for storing the surplus crude oil is running out, the contracts for the oil are expiring. As the demand is depended on the global economy which is in doldrums there is a risk of demand falling further. All these factors are further pushing the prices into the negative territory.
• Just a week before the stock of U.S. crude oil recorded an increase of 19.2 million barrels, as per the data made available by Energy Information Administration. At this rate of production in parallel to the demand taking the plunge, the surplus of 21 million barrels are finding no storage space. Cushing, Oklahoma is a place where WTI is physically delivered, will be having to place to accommodate this surplus.

How is Oil Trading Done?

Oil is being traded on futures contracts. The risk hedging factor plays a major role in buying and selling of oil. These contracts can be understood as the agreement, where two parties are involved, one is the buyer and other is the seller. Here one agrees to pay a pre-determined price agreed by the two for a pre-decided quantity of barrels which are to be delivered on a particular place on a particular day or to sell the given barrels at a pre-decided price on a date in future. The unstability of these futures markets has sent the prices below zero.

These contracts allows the companies to hedge the risks related to price fluctuations in the markets and make the financial environment predictable. It reduces their risk exposure. But in situations like these when the price and demand are falling while the storage space is running out, nobody wants to buy and take the delivery.

It can Happen Again !

• It was this uniquely rare occasion that led to the price drop. There was this unholy alliance of crashing demand, surplus supply and lack of storage space which culminated to this situation. And these factors can again come together to recreate this spectacle.
• On the part of fundamentals of finance, these things can happen again as similar situation arose many times during the economic meltdown of US sub-prime crises. In June 2020, it can again happen.
• Reducing or stopping the oil production right away will not solve the issue of storage.

Can't Stop Oil Production

• As the globe has paused to fight the Covid Pandemic, the major energy consuming sectors have also stopped working and the demand for the oil has reduce. Airlines industry has stopped, no flights so no purchase of Air Turbine Fuel. People are staying at home, no domestic demand for car fuels. Lockdown has reduced the cargo movement too.
• While contrary to this the oil supply has not fallen in the similar proportion. The major oil producing nations though in early April agreed to reduce the output of oil by staggering 10 million barrels per day which is equivalent to ten per cent. But the drop in demand is by 30 million barrels per day or more, this translates to rise is surplus of oil despite cutting down production.
• Oil wells are not like machines which can be switched off. While the supply has remained steady, it’s the demand which has crashed. But it is costly to shout down the oil extraction and even more costly to restart it. Thus, the oil extractors have much need to continue with the extraction even if they are undertaking it at a loss and when there are extreme situations they can pay the logistic costs to help the buyer purchase it!
• People mistakenly believes that oil is found in large reservoirs or pools and it can be just extracted by digging deep holes. You just have to locate the pool and drill it. It is a wrong assumption.
• The reality is that oil deposits are in the form of saturated oil in the porous holes. Imagine a sponge. You need to constantly apply high pressure to extract the oil out of the well. And as the well is being used for some time, it becomes difficult to keep extracting the oil. The technique to apply pressure becomes more costly and it becomes all the more costly to restart such a procedure or to drill new oil wells.

Retail Oil Prices Won't Come Down

• Despite the fall in the international prices for the crude oil, the petrol and diesel prices in India are still very high and has not registered a fall.
• As for the composition of the price of petrol in India, the base price i.e. the price of crude oil plays not more than 40 per cent weightage in determining the overall petrol price.
• Though the fall in crude has not translated to the retail prices, the low demand for oil has negatively impacted the revenues of state government.
• Government is trying to set off the losses by trying to impose more taxes on the fuel thereby taking advantage of the cheap raw material.
• For the current financial year 2020-21 the subsidy on petroleum products extended by the Government of India is budgeted at Rs 41,000 crores. It is a much smaller part of the total kitty of subsidies being extended by the government. Thus any savings on this will be puny while the loss in the taxes will be much significant.
• There has been recent increase in the excise duty on petrol and diesel by Rs 3 per litre in March and special excise duty was increase by Rs 2 to Rs 8 per litre for petrol and Rs 4 for diesel. Despite government efforts to make up for the loss, the reduced demand is not letting any ease on the financial health of the tax collector.
• Oil Marketing Companies (OMCs) are incurring heavy losses as the restricted movement of vehicles during the lockdown has crashed the demand. So to make up for the losses, the OMCs are not transferring the benefit of reduced crude oil prices to the final consumer.

Summarize

• While the fall of oil price into minus was a very technical, idiosyncratic event isolated to Cushing, Oklahoma, the press coverage of it really has created a sentiment shift.
• There is ‘Contango’, a kind of market condition where the commodity future’s contract prices are higher than the current value of the commodity, it represents the economic trust that the situation will improve soon in the coming months. Thus there is higher trading in June-July contracts as compared to May.

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