We are in the midst of troubling and perplexing times. Being associated with the financial markets for more than a decade, I thought I had seen it all with the recession of 2008 and the sporadic bursts of financial imbalance which lead to wild swings in the financial markets. But here we are living in a moment likely to remain a footnote and earmarked in the history - the catalyst of many things thought impossible but now turning possible given the current developments.
In the oil market, April 20, 2020 will be marked as the day in which the US price for crude oil slumped below zero for the first time and kept dropping. The futures contract for May 2020 delivery of WTI oil declined to a mindboggling minus $37.63 per barrel. Before the D-day, everyone thought this was unimaginable. At the most, the prices could drop to zero and in effect remove all its value. The downfall has revealed a glaring truth about the oil industry given the massive impact of the Coronavirus and the price war between leading producers. Oil is fast losing its value as abundant oversupply engulfs the global reservoirs, tanks and pipelines.
Paying to Sell Oil
For a rational producer, in the long run, it would be convenient than shutting down their production or identifying an area to store the supply extracted from the ground. Numerous producers are worried that closing the facility or plant might render them uneconomical in the future thereby damaging their reputation and the ability permanently. On the other hand, speculators who had bought huge contracts of crude oil betting on the price patterns have no intention of taking delivery of the oil barrels. These speculators are then caught by sudden drops in the value and are faced with the dilemma of either locating storage or selling at loss. With the escalating glut, traders choose the latter.
Oversupply Arena
As the COVID-19 spread across continents and the WHO declared it as a pandemic, it began shedding the demand of oil. With most economies declaring lockdowns to shield its citizens and slowing the transmission process, the world’s largest oil producers-Saudi Arabia and Russia also escalated the price war. A historical pact between these two powerhouses collapsed and both economies opened their supplies to the fullest thereby freeing record barrels of crude oil into the market.
Deal or No Deal
An initial deal was struck between OPEC, Russia, USA and a group of 20 nations calling for an overall production cut of approximately 10%. But the pact proved to be too little too late as the value turned negative in Wyoming, the USA where storage options are limited. This development spread to major hubs to register negative prices for other streams of crude contracts. All the signs progress finally lead to April 20 when the prices fell dramatically below zero on the NYMEX market, owned by Chicago Mercantile Exchange, the largest energy market in the world.
Why Futures Market
Futures markets are contracts in which a buyer locks a position at a stated price in the future. The markets offer measures for the users of oil to hedge against the price movements to mitigate the losses incurring in the upcoming days. The specific contracts run for a set period of time. Contracts for the May 2020 delivery were due to expire on April 21, inflicting maximum pressure on the traders. For these traders who were in a tricky situation, selling at a steeply negative price was far better than having to take delivery of the actual oil since the demand was declining and the storage units were fast filling up.
Storage Towards Full Capacity
The storage facilities were running towards full capacity since the glut began to unfold and prices dropped. The crude stockpiles at Cushing in Oklahoma had jumped 48% to 55 million barrels since the closing days of February. The industry practitioners had drawn innovative ways of storing oil in rail tanker cars along with storing aboard ships. The Trump administration is chalking a proposal to pay drillers to keep their oil in the ground temporarily. The basic idea is to keep the oil off the markets until the prices recovered protecting the producers from the immediate losses.
Conclusion
‘Scary’, ‘unbelievable’, ‘dramatic’, ‘unprecedented’ and ‘very visceral’ were some of the choice words used by Wall Street veterans to describe a historical day in the oil markets. The pandemic has sapped one-third of the oil demand as per reputed estimates. Although producers have continued to pump, oil has simply nowhere to go.
Vivek Risal is associated with Mercantile Exchange Nepal Limited in the capacity of Manager in Research and Development Department. He can be contacted at r&[email protected]
