NEGATIVE OIL PRICES

Suppose you are a trader in Future Market and deals in Exchange Trade Commodity. Now due to uncertainty in market, demand for that good fell and there will be physical delivery of that good once the trading window is closed. With “constrained storage capacity” and few days for the trading window to close, what will you do as a trader? Will you trade those futures at any price (+ve or -ve) possible or Will you take the delivery and store it where the cost of storage is higher than the gains from future contract?

INTRODUCTION : 

• US benchmark West Texas Intermediate (WTI) for May  delivery traded with $-4.29 on 20^th April and ended trading at -$37.63 a barrel on NYMEX ahead of 21st April close (lost 306% to settle) for futures contracts and expired at $10.01 a barrel, although Brent Crude and other benchmarks were in positive radar. 
• U.S. oil’s June contract drops over 43% to 21year low. 
• Overall, the energy sector is forecasted by Global Data to face downward earnings revisions of 208% in 2020, with the shock compounded by the oil price crash.

HOW OIL PRICES ARE DETERMINED? 

1. Physical side i.e. consumption led demand and Supply 

2. Financial counterpart i.e. future contracts, shares, etc. 

3. Different oil benchmarks are based on the density and sulfur content of that particular crude oil.

More sweeter the Sulphur content and lighter then density more it is preferred in the world market hence larger its market cap and higher is their price. Two of the most preferred benchmark in the oil world is the US-WTI and North Sea-Brent. 

FALL IN DEMAND FOR OIL :

• With the influx of Covid-19 pandemic, demand for crude oil fell by 23.1m bpd in Q2. 
• In India demand fell 18%, diesel in particular fell 24.23% by volume in March compared to the previous year. 
• It is expected that there will be decline of 7.6m bpd in refining output for India in 2020. 
• Chinese oil demand (largest importer by volume in the  world) dropped by over 3 million b/d in February. And refineries are operating at 20% percentage points 
• World liquid fuel consumption is expected to fall by 8.3%

SUPPLY RESPONSE AND THE PROBLEM :

EXPOSURE TO FINANCIAL MARKET

• The trade of oil in financial sector is much larger than the physical trade. Companies try to protect themselves from financial risks by future market operations. This includes specific contracts that are tied to specific grades of crude oil, as well as specific delivery dates at certain prices. 
• The Chicago Mercantile Exchange (CME) is the largest exchanges where this futures are traded in US. 
• WTI contracts are monthly contracts listed in current year and the next calendar 10 years and 2 additional contract months with settlement method being DELIVERABLE i.e. at the expiry of the contract there will be a physical delivery of oil to the traders. 
• Due to this the trading has to stop 3 days prior to the 25th calendar day of the month prior to the contracts month. In case of holidays its 4 days prior to the 25th day. 

Timeline for may contract 

• In April 2020, for a brief period, traders became desperate to get rid of the May contract, hence leading to negative prices of -$37.63. But it didn’t remained negative for a long time, before expiry the contracts turn positive again. 
• Henceforth the Futures for the next period started trading at low but positive prices. 
• The speculation of low consumption led demand deficit and surplus world production, as we can see in the graph to the right, led to this situation. 

• The key point to note is that, financial traders became skeptical for a brief period because of the fact that if they won’t be able to sell those future contracts, they might end up receiving the product itself and due to expected storage constraint in the coming month of May, it may lead to an increase in the logistic cost. 
• This also had an effect on the Brent prices though lesser but significant in lowering the overall world oil prices. o This was soon followed by Super Contango, where there was a step increase in forward prices in the market.

WHAT IS NEGATIVE OIL PRICE TELLING US?

• These negative oil prices tells us more than we have speculated. In the financial market, companies hedge their risk of price change and transaction takes place at the level of abstract on a computer screen without much involvement in the physical aspect of the commodity. 
• This economic shock has done is to expose the underlined vulnerability of a highly levered financial system with products created only to satisfy the motive of earnings through returns. Thus the constraints and leverage created by the commoditized financial system has amplified these frictions to unthinkable levels.