West Texas Intermediate (WTI) crude oil price went below $1/barrel on 20th April’2020. Then price went to a ridiculous negative level (below $0). Yeah, you read it write.
WTI contracts have major significance to US oil prices as a reference.
People shocked and surprised took to Twitter to fathom the fact. Like, how does it even work? Does it make any sense? Does it mean oil is worthless? Sounds ridiculous, right?
Short explanation: Oil trading or consuming companies who were supposed to buy from oil producers already have a lot in stock due to low demand and nowhere to store any extra oil. Hence, they square off their contracts to avoid any delivery when contract expires. This leads to fire sale and WTI contract starts trading at a very low price.
Long explanaton: TLDR – ALERT!
Though this example is far from reality, but putting it simply for the sake of understanding. Disclaimer for hardcore commodity traders or energy market gurus. 🙂
Phew! Well, we can see it like this.
Whats is the city of Wonderland?
There is a small city of Wonderland with only 3 companies – Oil Co, Chemicals Co and Petro Co. Lets say, Oil Co as an oil producing company sells all its produce to only these two buyers. Chemicals Co uses this oil to produce different chemicals and bi-products which are sold directly to consumers in the city market. Similarly, Petro Co buys from Oil Co to produce petrol/gasoline which fuels vehicles of people living in that city.
A month ago, Oil Co signs two separate contracts with Chemicals Co and Petro Co to sell 500 Litres of oil to each of them by the end of month. It means by the end of month, both of these buyers are supposed to take delivery of oil against a payment to Oil Co. Oil Co benchmarks/references prices of its oil contract basis prices being traded on international exchanges everyday. Hence, oil prices fluctuate everyday due to change in global demand and supply. Oil Co estimated revenue to be $20,000-$25,000 (assuming oil prices will be around $20 to $25 per Litre at the end of the month, which is the time when contracts are supposed to settle).
But to its dismay, world took a hit from a deadly Covid-19 pandemic. Even the city of Wonderland was nowhere safe and city admins had to announce lockdown. Just like other people around the world, citizens of once charming Wonderland are now unable to make daily wages, they don’t get out to buy stuff frequently. Hence, drop in demand for consumer bi-products and vehicle fuel. Chemicals Co and Petro Co suffer a deep blow in their working capital and cash, as they have already bought a lot of oil as raw material and produced end products which are already in unsold stock. With the remaining cash, they are paying for salary of employees and rent for the warehouses, tankers and infrastructure they use to store oil and products made out of it.
When month end arrives, Chemical Co and Petro Co do not have additional storage to take delivery of oil from Oil Co. Similar is the story of other oil traders around the globe, hence they sell the once bought contract and book a loss in order to avoid a physical delivery which can have even far bigger consequences, they don’t have anywhere to store, remember? This fire sale by traders around the globe leads to a plummeting oil price even to an extent that it turns negative.
Negative oil prices in a way signify that Oil Co (producer) will in turn pay money to buyers to get rid of oil in its stock.
But why does Oil Co have to trade oil at negative prices, can’t it just stop production until oil prices stabilize again?
Oil Co is in dilemma. It can try to cut down its production, but can’t shut-down its plant completely as it may have even bigger consequences on its operations. So, Oil Co just want to sell oil contract to buyers at whatever-the-price-be with a hope that oil prices should stabilize soon. Prices also plummet due to sentiments in trading. Does this indirectly mean that oil is “WORTHLESS” or has “ZERO DEMAND”?
“Does this indirectly mean that oil is “WORTHLESS” or has “ZERO DEMAND”?”
At least, that’s what the values signify for that point of time.
Hmmm, interesting! But, in actual world, that’s not the case. Oil prices might be getting traded at near 0 price for now, but they are bound to recover. Though demand is apparently LOW, but it is not ZERO. We are still going to fuel our vehicles, fire our stove and after a few days (or maybe months) fly around in planes. Hence, oil prices can’t sustain this price and are bound to bounce back.
Another fact from the real world (contrary to the city of Wonderland): Oil prices dropped to negative territory only for WTI (May Delivery), where as Brent is still trading around $25 (for June delivery). When current stock starts to go down slowly with slow demand, oil traders are going to take physical delivery again. Though it might be at a relatively small position, but this is inevitable.
“This might not signify recovery, but it certainly signifies hope. I believe, sometimes that’s all we need. For now, all we can say is that we’re witnessing a historic event that we might not witness again in our lifetime.”
Please let us know your views through your comments below
Covid-19 India Outbreak – 20th April’2020
India reported 1,580 new Covid-19 cases taking toll of the total confirmed cases to 18,539 as of 20th April’2020. The positive news for India is jump in the recovered case by 419 with 3273 recovered cases. The Covid-19 disease has taken 592 deaths in India. Among all the states Gujarat moved up in the list on no. 3 position with 1,939 confirmed cases.
*WTI/Brent: A grade of crude oil used as a benchmark in oil pricing.
*NYMEX WTI: Contract/instrument to trade WTI crude. It is used as a benchmark for nearly one-third of world’s pricing, hence indirectly impacting one-third of world’s demand. Brent represents nealy two-third.
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