The United States oil markets created history on Monday when prices of West Texas Intermediate (WTI), the best quality of crude oil in the world, fell to “minus” $40.32 a barrel in interlay trade in New York. Not only was this the lowest crude oil price ever recorded — according to Bloomberg, the previous lowest was immediately after World War II — but it was also well below the zero mark.
At this price, the seller of crude oil would be paying the buyer $40 for each barrel that is bought.
But how can that be? How did prices fall below zero in the first place? Why would they fall from $0 to -$5 to -$10 and then all the way to -$40 a barrel?
Crude oil is not like daily household waste that one wants to pay to get rid of; it is indeed an essential component for modern life and economic growth. So at one level, the negative pricing of oil is misplaced.
Yet, even though it may look so, this is not an illogical result. In fact, there have been instances of commodities being sold at negative prices. For instance, natural gas hit negative prices in May 2019 in the US. Moreover, the banking industry has seen negative interest rates — where one pays the bank to keep one’s money — and bonds have been known to have negative yield, in which a bondholder makes a loss by lending money.
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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 (see Chart 1). To a great extent, oil markets, globally and more so in the US, are facing an enormous glut.
Historically, the Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, which is the largest exporter of crude oil in the world (single-handedly exporting 10% of the global demand), used to work as a cartel and fix prices in a favourable band. It could bring down prices by increasing oil production and raise prices by cutting production.
In the recent past, the OPEC has been working with Russia, as OPEC+, to fix the global prices and supply.
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.
The global oil pricing is by no stretch an example of a well-functioning competitive market. In fact, its seamless operations crucially depend on oil exporters acting in consort.
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, oil-exporting countries, led by Saudi Arabia, started undercutting each other on price while continuing to produce the same quantities of oil.
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. With each passing day, the developed countries were falling prey to COVID-19 and with each lockdown, there were fewer flights, cars and industries etc. using oil.
What was the impact of the COVID-19 outbreak on oil prices?
By the time the discord between Saudi Arabia and Russia was sorted out last week, under pressure from US President Donald Trump, it was possibly too late (see Chart 2). Oil-exporting countries 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.
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It is also crucial here to understand that the US became the largest producer of crude oil in 2018. And that is one reason why, unlike all previous US Presidents, who always pushed for lower crude oil prices, especially in an election year, Trump has been pushing for higher oil prices.
What happened on 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.
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 (buyers) or stopping production (producers).
What is the future of oil prices?
It is important to note that it was the WTI price for May in the US markets that went so low. Crude oil prices elsewhere fell, too, but by not so much. Moreover, at least for now, oil prices for June and the coming months are pegged between $20 and $35 a barrel.
It is possible that this was a one-off event where prices dropped below zero because of an existing glut in WTI oil, which is found inland, and there was no space to store or transport it in a hurry.
Investment budgets of exploration and production companies are expected to drop in the face financial turmoil due to low shale oil prices. Normally, this should force oil exporting countries to cut back production and negate the excess supply, restoring some balance in the oil markets.
But one cannot rule out a repeat of Monday’s trend because, with COVID-19 continuing to spread, global oil demand is falling every day. In the coming quarter, some estimates claim that total demand will fall by 30%.
In the end, it would be the demand-supply mismatch (adjusted for how much can be stored away) that will decide the fate of oil prices.
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 (see Chart 3).
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.
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