The oil industry is in a crisis like it’s never seen before, with the double-edged sword of excessive supply and a shocking dip in demand due to the corona virus global shutdown. Producers have been given the harshest signal ever to react to this crisis pronto. Planes aren't flying, shipping is almost on the halt and the consumers, especially Americans who consume 10 per cent of the world's oil output in their cars are staying indoors.
Although the mind-boggling question is that whether the oil prices have gone negative literally? In other words, if you buy oil, instead of paying, you are going to receive money. That doesn’t sound right, does it?
Firstly, we have to know that this whole scenario is based on the situation of the US commodities exchange. Looking at the macroeconomic factors, the world is currently facing a lockdown hence the demand for crude oil and its refined products have been hit hard. Brent crude oil serves as the benchmark of crude oil in the international market.
Fun fact: In January 2020, the price of Brent Crude oil was $62 which in April 2020 is down to $26.
Although the price is still at $26 and nowhere near zero, let alone negative. This is where the US exchange comes in where they have WTI (West Texas Intermediate) as their crude oil benchmark. The futures contracts of WTI are traded on the US commodities exchange known as NYMEX (New York Mercantile Exchange). A futures contract is simply a contract that has a future date of execution. Every month, an opportunity to enter a futures contract is open for us all. A contract has an expiry date as well which means that if you wish to execute the contract i.e. you want to buy the commodity in exchange for the pre-decided price, then you may hold onto it till the expiry. There is also a provision for you to exit the contract by selling it before the expiry on the exchange. In India, the last Thursday of every month is the expiry date of that month’s future contracts. These dates may differ in other countries but is usually a day in the last week of the month.
The WTI futures contracts for the May month had an expiry date of 21st April 2020. On 20th April 2020, news came that the US storage facility situated in Cushing (a city in the US) for crude oil is almost saturated. Now for those who will buy the WTI futures on the NYMEX get their delivery of oil (in case they hold on to their contracts till expiry) from Cushing only. This got the traders panicking.
The reason for this panic is simple. If there is no storage capacity left for crude oil, where will they store it after they have bought it? The demand for oil is already dipping every day hence the price will go down further. In addition to this, even if they buy the oil and wait till the prices go up again, firstly, they'll have to find storage for this oil and secondly, they'll also have to bear the cost of it (maybe for long duration). Generally, when people are delivered with their commodities, they either consume it or sell it, hence no expenditure for storage. With all this going on in the market, the traders were left with no other option but to sell their existing contracts for whatever prices they can get out of it. When the NYMEX opened on 20th April 2020 (expiry of contracts 21st April 2020), the price for WTI crude was at $18.
When the NYMEX opened on 20th April 2020 (expiry of contracts 21st April 2020), the price for WTI crude was at $18. When traders started selling their contracts collectively, it led the prices into the ground. The price went to $0 and further to a low of $-40. Hence, the individuals who sold their contracts at this time had to pay the buying party money from their end as well for their contracts. If they had done otherwise then they would have had to take the physical delivery of WTI crude making them firstly find a storage place for it and secondly paying for it. Hence to dodge all these expenses they didn’t hesitate to sell their contracts for a negative price as they feared that these storage expenses may turn out to be more than the negative price they are paying today.
The Brent Crude oil is still nowhere near $0 as the other countries have not reached the limit of their crude oil storage capacity. So, it wouldn't be wrong to say that the massive dip of crude oil price was limited to the US borders only. Although if other countries do not learn a lesson from this then they will also end up the same way as the US did.
But then there is another catch to this. If the whole problem is the demand and supply graph, then why not just cut supply for the time being and replenish it when the demand turns up. It’s not as easy as it sounds. There are two reasons for it. Firstly, the oil-producing countries are not halting their production as it is a very difficult and complex process. Even if they do it somehow, the cost and time for initiating it again are far too high. Secondly, these countries' GDP relies heavily on their oil exports. If they stop exporting it, there is a fear that the importing countries may divert to other countries for oil. This will put them under the risk of losing their market share which may affect their GDP further. The same happened in the March month of this year when Russia denied the oil-producing countries to halt its production or to even reduce it. This has led to an oversupply of oil in the world leading to its reduced prices.
Some speculators may even predict that the Indian government may provide us with petrol and diesel at reduced prices in future. The chances for that are slim as there are two reasons for it. Firstly, the Indian currency against the dollar is depreciating quickly and is somewhere near Rs.77 for $1. We know that India imports about 82% of its crude oil to fulfil its domestic demand. For that, we have to pay in dollars. The more the currency depreciates, the more price we will have to pay for our imports. Even if the reduced crude oil prices compensate for the depreciated Indian currency, there is still a very remote chance that we see a reduction of oil prices in the Indian market. Petrol and diesel are a major source of tax revenue for the government. They do not fall under the purview of GST making the government levy heavy taxes on it to gain more revenue and reduce its fiscal deficit as much as possible. If we talk about only petrol, including the excise duty and VAT we pay almost 100 per cent of the tax on it. Last month, the government saw the downtrend in oil prices and increased the excise duty on petrol by Rs.3 per liter.
Hence, the chances for us Indians to gain much from this situation are not looking good. Still, it depends on many other parameters that I wasn't able to cover. Whatever happens, we will know through the regular course of time.
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