The coronavirus pandemic has caused a series of mind-bending distortions across world financial markets, but Monday (20th April) featured the most bizarre one yet: The benchmark price for crude oil in the United States fell to negative $37.63. It is a historical moment in the Oil market indicating that producers would have to pay the buyer to take oil off them. Why someone would do that? Lack of storage space to hold a plethora of crude.
Why WTI is negative and not other benchmarks like Brent Crude?
Before we go into detail about why WTI plummeted, let's understand what is WTI?
There are two major indices for crude oil :
- WTI or Western Texas Intermediate — WTI is extracted from oil fields in the United States. It is primarily extracted in Texas, Louisiana, and North Dakota and is then transported via pipeline to Cushing, Oklahoma for delivery. Cushing was a major spot for oil for decades and has been the delivery spot for contracts and price settlements for WTI for more than 30 years. It contains 0.24% sulfur. WTI futures contracts are traded on the New York Mercantile Exchange (NYMEX).
- Brent Crude — Brent crude is extracted from oil fields in the North Sea. ‘Brent Crude’ refers to a blend of four crude oils — Brent, Forties, Osberg, and Ekofisk which together are known as BFOE. It contains 0.37% sulfur. Brent futures contracts are traded on the Intercontinental Exchange (ICE) in London.
WTI went into negative territory because of the physical settlement of barrels, whereas Brent crude didn’t because settlement happens on a cash basis. Secondly, Brent oil fields are located in the North Sea so it’s easy to store crude in tankers. There are also another two major reasons which slide the oil future contract prices to negative.
A. Coronavirus Effect: -
· Most of the countries are lockdown due to coronavirus. The government has asked people to maintain social distance. So, people prefer to stay at home rather than going out.
· Over the last six weeks, demand for products refined from oil has collapsed. With far fewer airplanes flying, airlines need less jet fuel. People aren’t driving, so they need less gasoline.
· The supply-and-demand balance for oil is so out of whack that global demand cannot grow fast enough and suppliers can’t cut supply quickly enough to put things back in order. There is so much oil sloshing around the world but only a few people are using it.
B. Russia — Saudi Price War: -
· Beginning in 2014, U.S. shale oil production increased its market share; as other producers continued producing oil, prices plummeted from $114 per barrel in 2014 to about $27 in 2016.
· In September 2016, Saudi Arabia and Russia created an informal alliance of OPEC and non-OPEC producers that was dubbed “OPEC+” to manage the oil price and supply management.
· After the falling demand for oil, OPEC and other oil-producing countries agreed to cut oil production by an additional 10 million barrels per day through the second quarter of the year 2020.
· OPEC also expected non- OPEC members (Russia & Mexico) to contribute to this deal. But Mexico and Russia’s reluctance to cut oil production left the deal in limbo. To retaliate, OPEC members started more production and increased their daily production by three million barrels and flooded the world with excess supply. It made difficult for US shale oil companies to reach out to the market and make money.
· After Trump intervene between the deal and requested Saudi Arabia, Russia to cut down the production. Twenty-three oil-producing countries in the group known as OPEC+ have agreed to a 9.7 million barrels per day cut, starting on May 1, 2020, for an initial period of two months. This is the single largest output cut in history.
What’s next?
There has been significant economic damage in oil-producing countries beyond OPEC and Russia, including Argentina, Brazil, Guyana, Ivory Coast, Malaysia, Indonesia, Azerbaijan, Kazakhstan.
Bankruptcies, unemployment, likely to increase in U.S. states where the oil industry is the major employer. The United States could find a way to buy barrels of oil to slash them in the national Strategic Petroleum Reserve, which would take some pressure off commercial inventories like those in Cushing. Also, the USA is planning to raise tariffs on imported crude by Saudi & Russia.
In order for oil prices to find their footing, demand for crude has to make a comeback. But this is only possible once the lockdown period is over and fear of coronavirus is over among the people. Government all over the world is re-opening the economy partially, but even with nominal activity in an economy won’t help to increase the oil demand.