This article is written by Abhay, a student from Kirit P. Mehta School of Law, NMIMS and modified by Gitika Jain pursuing from Amity University, Kolkata. This is a comprehensive article which deals with various aspects associated with the decrease in the price of Oil around the world.
Table of Contents
Introduction
The coronavirus outbreak has triggered a variety of mind-bending anomalies around the international financial markets, and the most surprising one is that the selling price of crude oil in the United States has fallen to negative. The COVID-19 crisis is a significant deflationary blow to the world, causing a massive proportion of the world’s productive capital to idle.
The implications will almost certainly extend past the time of widespread lockdown. The oil industry has been having trouble to reduce production with both the falling demand and the in-fighting between producers. The fall in oil prices, which has plummeted by about two-thirds since the beginning of the year for US drivers that also had an impact on the pumps.
OPEC deal
Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental institution formed by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela at the Baghdad Conference on 10–14 September 1960. The aim of OPEC is to integrate and consolidate petroleum programs among the Member States to ensure low and equitable values for oil producers. OPEC leaders and their allies eventually decided earlier this year on a historic agreement to cut global production by about 10 per cent. The deal was the biggest cut ever reached in oil production. But other critics believe the cuts weren’t sufficient to make a change. OPEC’s major exporters and partners including Russia have already decided to slash demand by a substantial amount.
Oil generating companies in the United States and beyond have made strategic choices to slash production. But the planet already has more crude oil than it could make use of. This hasn’t taken the industry long to realize that the OPEC agreement is not going to be enough in its current form to stabilize oil markets.
The price of oil
The price of oil generally applies not to an actual barrel of oil, but rather to the price of a futures contract that has been traded on the Chicago Mercantile Exchange. In oil futures, one contract equals 1,000 barrels of crude oil. Either by personally taking delivery of the oil or by resolving the deal by selling it to some other buyer in return for money could be considered as a settled future oil deal. In oil futures one contract represents 1,000 barrels of crude oil and an oil future contract can be closed either by physically taking delivery of the oil or by settling the contract by selling it to another buyer in exchange for money.”Price of oil” is defined as the current per barrel price expressed in the next month’s futures contract.
A lot of big companies exchange these contracts without really caring much about the practical details. This implies that the oil companies are paying consumers to move the oil from their hands. This was done over concerns that the storage space might run out in May. The dried up demand for oil has led to this situation. As lockdowns around the world have held everyone indoors. As a consequence, oil companies have turned to lease tankers in order to hold the excess stock, dragging US oil prices into negative.
Speculators estimate businesses cover their costs of market volatility, and trades occur at the uncertainty stage on a computer. Financial speculators sell their contracts to “actual” oil buyers, including refineries as the date of settlement of each contract approaches. This creates problems for traders and some end up almost having the physical delivery of a ton of oil. The price of crude barrels differs according to variables such as availability, demand and quality. Fuel production is well beyond demand, as the coronavirus has stopped people from all over the world to travel.
Situations that led to the negative price of oil
The demand shock was so huge that everything that anyone might have anticipated was overwhelmed. Oil trading is done on its future value and contracts for the futures were due to expire. Traders were eager to discharge those stocks to avoid taking shipment of the oil and accrue storage costs.
Attempts were made by sellers to unload crude, for which there was clearly not enough physical demand or storage space. Owing to COVID-19, demand for oil-refined goods has plummeted. For much less aircraft flying, airlines don’t have to use much jet fuel. People don’t drive, so they need less fuel.
But oil companies have been slower to reduce production. All the normal places to stock it were full, and thus negative futures prices caused the market to clear up. More than anything else, the economic consequence of the pandemic is a complete cessation of production. There might be a few items with shortages, including medical supplies, personal protective equipment and disinfectant wipes.
But the wider picture is that a substantial share of significant economic production is actually on hold. This covers obvious candidates such as hotels, airlines and sports stadiums which are left empty. It also includes quite obvious ones such as the auto industry, which has effectively shut down factories.
It also involves the energy sector, with far more ability to extract oil from the ground than what is currently necessary, and with limited storage space. All of this leads to a deflationary crash, i.e. a crash in the availability of products and services and, subsequently, a spike in rates that exceeds everything as seen in most people’s lifespan. Oil is not the only product with a falling price.
WTI (West Texas Intermediate) oil is traded in the NYMEX (New York Mercantile Exchange) as futures contracts, where traders buy and sell monthly futures such as May futures, June futures, etc. Sellers of these futures would have to supply a barrel of crude oil at the agreed price in the contracted month just as the purchasers would need to take delivery on the agreed date.
Like with most commodity trading, there’s also huge speculation involved in the oil futures trading. Thus speculators buy and sell contracts without any intention of taking the delivery or delivering physical oil on the date mentioned in the contract. Those speculators should unwind their “positions” on the expiry date of the contract. If the speculators are not successful in doing it, then they have to take physical delivery of the crude oil on the agreed date.
Speculators who made big predictions on May futures started to relax their positions. Those who did not plan to take physical deliveries had to settle their contracts prior to that of the expiration. The ones who didn’t take delivery in May went on to unwind their positions, which led to a massive drop in price.
It may be that these financial speculators never took any physical delivery and closed their contracts. In other situations, they could be delivery based traders who backed out on seeing the fallen demand of oil. The bottom line, however, is that prices were falling as demand for oil was dropping and the world was running out of storage capacity, particularly America.
Future rates for June are still at $20.43 a barrel, as traders are of opinion that the demand will rebound by June if the worldwide lockdowns get lifted and economic activity picks up the pace. Traders also expect that storage facilities could be created, if the current stocks are depleted after lockdown.
It is a time for traders to buy the cheap oil and stockpile it. So, in future when the situation becomes normal, they can sell the same for more price. Such a pattern became popular during Iraq’s 1990 invasion of Kuwait when a dealer took large positions ahead of the invasion at cheap rates and sold them as prices increased after the invasion. Oil was stored in sea-floating tankers and were discharged at slightly higher costs.
Today, the traders have done the same. Year-long VLCC (very large crude carriers) that have a capacity to store up to 2 million barrels of oil is soaring all-time high. This demonstrates that the rising demand for these floating storage has increased to gain advantage of the negative prices of oil. Perhaps, the concern is that these floating storage very easily runs out of capacity; America’s land storage is already overflowing. This clarifies why oil prices fell drastically.
Current scenario
The demand for global oil fell by 25% in April, but cutting its losses to just 8%, it has rebounded sharply since then. To look further, remaining lower than it was at pre–COVID-19 levels(about 4% lower in the base case, and about 7% lower in Rystad Energy’s second-wave scenario), 2021 oil demand is expected to recover strongly. Since July 2020, oil prices and energy stocks have underperformed base metals and the broader S&P 500 index by about 10% and 25% and 6% and 10%, respectively. Continuing to challenge the industry’s reputation as a reliable employer, Mass layoffs and heightened cyclicality in employment. By the end of 2021, US O&G companies laid off about 14% of permanent employees in 2020, and 70% of jobs lost during the pandemic may not come back and the pace of recovery remains highly uncertain as pertaining to COVID-19 cases during winter conditions, especially in Europe and the United States, may trigger another round of shutdowns and restrictions by the end of 2021. Economies are expected to continue dealing with the adverse impact of deteriorated fiscal balances even when the virus is controlled and the effect of muted business investment on the labor market and consumer spending in 2021.
Effects of negative price
The historic value drop is a sign of the pressures that the oil market is undergoing, and prices are expected to decline if lockdowns remain in effect. The adverse value of US oil will have an impact on several companies that operate in the North Sea and this is not just about whether we will be able to use it or not.
Storage facilities have become so filled due to excessive supply that it is hard to find any storage. There is no longer any storage available and the product price is essentially zero. This is also a question of how we can hold it before the lockdowns are relaxed enough even to create any extra demand for oil services.
Capacity fills quickly at sea and onshore. For weeks analysts have cautioned that the rapid depletion of spare storage capacity would mean that oil drilling and refining would have to be stopped in several regions. For temporary, producers may consider prices below their variable cost as long as they can offset some of the costs which they have to sustain even if oil production closes down.
The fall in prices of crude futures does not automatically turn into a price collapse at the gas pump. The fall in oil prices would make running flights affordable for cash-strapped airlines, which are already virtually empty as people stay homebound due to the coronavirus.
The drop in crude futures also shows that perhaps the market is not expecting airlines to return many flights to their scaled-down networks at any time. The price of crude June contracts also decreased, dropping to $20.43 a barrel by 18.4 per cent. This is a much more accurate picture of how in the near future traders can think about market demand for oil. It’s not below zero but it’s rapidly dropping.
India would gain from the price collapse in two ways. First, this financial year, the oil purchase cost will drop sharply, giving the government considerable relaxation on the external budget side. With India’s merchandise exports hit hard because of the West’s lockout, overseas-exchange revenues are already under a lot of pressure.
Secondly, the pressure on the current account balance is less due to the decrease in the price of oil and the reduction in the foreign exchange. In fact, if the recovery of the world economy and the exports from the situation created by corona is rapid, then the positive balance in the current account is possible.
India is gradually building its strategic assets, profiting from the low prices. India has a capacity to handle more than 39 million barrels of oil in its oil reserves near Udupi in Visakhapatnam, Mangalore and Padur. These have been converted underground salt caverns designed to hold crude oil.
When time progresses on, ever more projects will be stopped and a new equilibrium will be formed between supply and demand at rates that surpass the overall production cost.
Conclusion
The bottom line is power isn’t going to go away overnight. If the economy starts improving, the oil would still be in the ground; the unemployed will be willing to return to work, and the stadiums and hotels will reopen. Yet, longer the deflation lasts, the more are the chances of some long term damage to the economy.
The adverse value for the futures contract can be interpreted as a strange aberration on the oil market, there is a much more important point. A sharp rise in American energy output over the past few years has outstripped the world’s need for energy, particularly if most of the changes arising from the pandemic continue for months or even years, including less air travel.
US President Donald Trump has said the government is purchasing oil for the national reserves of the country but fear remains mounting that US storage facilities will run out of capacity. The coronavirus pandemic has led us to stop travelling and has limited economic activity. This is a disturbing indication of an unprecedented global energy glut.
The economy is all about demand and supply; and production and consumption. The problem for the post-pandemic economy is whether the lost equilibrium can be revived soon or not. It will be far more difficult to do this than to identify further places to store the current oil.
References
- https://globalriskinsights.com/2020/05/making-history-coronavirus-and-negative-oil-prices/
- https://fortune.com/2020/04/20/oil-prices-negative-crash-price-crude-market/
- https://www.bbc.com/news/business-52350082
- https://www.institutionalinvestor.com/article/b1lhy2h328jhpt/Inside-the-Biggest-Oil-Meltdown-in-History
- https://economictimes.indiatimes.com/markets/commodities/news/what-led-crude-oil-prices-fall-below-0-a-barrel/articleshow/75264813.cms?from=mdr
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