Why are oil prices in negative terrain?
Sellers have to pay buyers to get rid of their crude, an unprecedented situation
- Prices of West Texas Intermediate (WTI), the American benchmark for crude oil, fell to less than zero.
- The price of a barrel of WTI fell to minus, $37.63 a barrel. What this means is that sellers have to pay buyers to get rid of their crude. This is unprecedented in the oil market, even accounting for its notoriety for being volatile.
- WTI oil is traded as futures contracts in the NYMEX (New York Mercantile Exchange) where traders buy and sell monthly futures such as, for instance, May futures, June futures and so on. The sellers of such futures will have to deliver a barrel of crude oil at the contracted price in the contracted month just as buyers will have to take delivery at the contracted date.
- As with all trading in commodities, there’s a huge speculative participation in oil futures trading too. So speculators buy and sell contracts with no intention of taking delivery (in the case of buyers) or offering delivery (in the case of sellers) of the physical oil, on the contracted date.
- These speculators have to unwind their “positions” on the contract expiry date. If they fail to do so, they will have to take physical delivery of the crude oil on the contracted date.
- The speculators who had taken large bets on May futures began to unwind their “positions”. Those not intending to take physical delivery have to square off their contracts before the expiry date.
- So, speculators who did not want to take delivery in May proceeded to unwind their “positions,” leading to the massive fall in prices. The bottomline, though, is that prices fell as demand for oil is falling and the world, especially America, is running out of storage space.
- America is also talking of adding to their strategic storage by taking advantage of the low prices. This could create demand for oil. Finally, contract expiry for June contracts is still a few weeks away, giving speculators that much more time to speculate.
- Brent oil has traditionally quoted higher than WTI with the gulf being about $6-7 a barrel between the two. Brent is a superior grade produced in the North Sea off the British coast and is the accepted benchmark for this part of the world. The market that it serves is considerably larger than that of the United States and demand is, therefore, higher.
- Transporting oil from the U.S. to Asia is not economical thus limiting the scope for the WTI grade. Refineries in Europe are configured for Brent rather than WTI. Prices of Brent are therefore always higher than that of WTI. Importantly, unlike WTI futures on NYMEX, Brent futures traded in London can be settled by cash when the contract expires.
- In other words, a trader who has bought oil for May delivery is not forced to take physical delivery of the oil but can settle the contract in cash. This big difference between WTI and Brent has ensured that Brent futures will not crash like that of WTI.
- The oil import bill will fall sharply this fiscal year, giving tremendous relief to the government on the external account front. With merchandise exports from India badly hit due to the lockdown in the West, foreign exchange earnings are under pressure.
- With oil prices falling and foreign exchange outgo reducing, the pressure on the current account balance is off. In fact, we may be looking at a positive balance in the current account if global economic recovery is quick and our exports recover.
- India is quietly building up its strategic reserves, taking advantage of the cheap prices. India has a capacity to hold over 39 million barrels of oil at its strategic reserves in Visakhapatnam, Mangalore and Padur, near Udupi. These are underground salt caverns converted and built to store crude oil.