This article is written by Nisha Dharod. In this article, the author explains the reasons for the drop in prices and the economic slowdown during the lockdown period.
Table of Contents
21st April 2020, almost a month into lockdown, talks about global economic slowdown which were being debated upon, by intellectuals all over the world, somehow caught the glimpse of reality when the oil prices dropped beyond zero and entered the negative territory for the first time.
May Futures contracts for WTI or West Texas Intermediate on Monday closed at – 37.63$, a day prior to their expiry on Tuesday. In simpler terms sellers instead of receiving payment for oil were paying buyers to take oil out of their hands. To put it in a sentence, barrels were costlier than the oil in it. While U.S.A’s WTI was trading in negative, Brent Crude was still trading in positive at about 20$ per barrel.
Before zeroing in on how did the oil prices breach the 0$ per barrel mark and turned negative in a day’s time, it is necessary to have an overview about the oil industry.
Crude Oil or as is commonly known as “kachha tel” is found in some parts of the world with Middle eastern countries being the biggest oil producers around the globe. In fact, Saudi Arabia alone produces around 45% of the total (global) oil requirement. Crude oil can be extracted either from land or from sea. Oil which is extracted from land is transported via pipes and is stored at delivery points which makes it an expensive product, while the oils which are extracted from sea are transported via ship containers which provides the oil producers with an extra storage place and is cheap in comparison to the former.
Oils extracted from the different parts of the world differ in quality, in the manner that oil extracted from a particular location may be light in weight, while some may be heavy, some may have high sulphur content and so forth, which makes it impossible for oils extracted from different parts to be valued against one single benchmark. As a result different benchmarks are developed against which the oils are valued.
As for instance, the oil which is extracted from the oil fields in the North Sea between the Shetland Islands and Norway is known as Brent Crude and the subsequent benchmark against which it is valued is known as BRENT. Almost 2/3rd of the oil contracts around the world are valued against Brent. Organization of Petroleum Exporting Countries i.e. OPEC, a group of 14 of the most powerful oil-exporting countries, use Brent as their pricing benchmark.
Prior to 2000s U.S.A was an oil-importing country, however, between 2010 and 2014 there was an unprecedented revolution in the U.S. oil industry which came to be known as Shale Energy Revolution. The U.S. developed a profitable way of drilling out oil from wells through the combination of hydraulic fracturing and horizontal drilling which came to be known as Shale Oil. The Shale oil technique was so revolutionary that within a decade the U.S. emerged as the number one oil-producing country in the world surpassing Russia and Saudi Arabia. Subsequently, WTI was developed as a benchmark to value the crude oil produced in the U.S.A. WTI is the underlying commodity for the NYMEX’s (New York Mercantile Exchange) oil futures contract.
West Texas Intermediate or WTI and Brent are the two most popular benchmark in the world and practically dominate the oil market
If we rewind into the history when the Shale technique was not yet discovered, Russia and Saudi Arabia primarily controlled the oil market. Saudi along with the OPEC Countries produced up to 45% of the world’s oil demand and prima facie dominated the market.
Introduction of Shale Energy miraculously changed the market position, making U.S. the largest oil producer in the world. As the Shale technique enabled the U.S. to drill oil out of wells in a profitable manner, they were able to sell oil at a discounted price than Brent thereby providing a stimulus to WTI.
In order to retain their respective market share, all the oil producing countries started producing oil in huge quantities and selling them at a discounted price. This made it difficult for the oil producing countries to earn profit and especially for smaller countries whose entire economy was dependent on oil such as Iran, Iraq, Kuwait and so on. As a result in December 2016, an alliance was formed between OPEC and Non-OPEC countries which included Russia, Mexico, Kazakhstan and Azerbaijan amongst other countries to control the oil prices and thereby retain their market share. This agreement which came to be known as OPEC + or OPEC plus is an alliance between 24 oil producing countries. Together these countries controlled 55% of the world’s oil production.
As the coronavirus spread increased drastically in the month of March, the entire world went into a frenzy. Due to complete inactivity around the globe, the oil requirements in the form of petroleum, jet-fuel, shipping industry and other requirements fell down drastically, with very less demand for oil in market. In fact, the statistics quoted by the International agencies, show that the average oil demand which was 100 million barrels per day, owing to the pandemic plunged down to almost 30 million barrels per day.
As oil was being produced at a constant pace, supply in the market surpassed the demand causing prices to fall further. In order to prevent the situation from further deteriorating, a meeting was staged in Vienna on 5th March between the OPEC countries to collectively control the oil production and it was decided that the oil production will be reduced by 1.5 million barrels per day and the same was agreed by Non-OPEC Countries.
However, Russia refused to bring down the production but instead increased its oil production, breaking the alliance between Saudi Arabia and Russia. There have been many speculations as to why Russia refused to put a brake on its production, but one of the main reason was that Russia wanted to attack U.S.A by destroying its oil industry as U.S.A in recent past had imposed various sanctions on Russia.
As Russia and U.S.A continued producing oil at a constant rather increased pace, even Saudi Arabia started producing oil in contradiction to the Vienna agreement thereby flooding market with prospective sellers but no buyers. Thus the market was caught in a double whammy, fighting the pandemic and witnessing the standoff between U.S.A, Russia and Saudi Arabia. The following week, crude prices slid below 30$ per barrel.
Following the breakdown of Vienna agreement, on April 13, U.S.A successfully induced Russia and Saudi Arabia to enter into a tripartite agreement whereby the 3 oil producing countries would cut down their oil production by 10 million barrels per day. While this is an unprecedented agreement and a commendable one, cutting down production by 10 million barrels which amount to 10% of the total production will still outweigh the demand which stands at an average 30 million barrel per day.
Why did the Oil Prices Fall?
If we revisit the background of the article, there was a line which stated that oil could be extracted either from land or from sea. Oil extracted from sea is easily transportable and cheap in comparison to the oil extracted from land, which has to be transported via pipes who transport them to a delivery point and is therefore expensive in comparison to the oil extracted from sea.
Oil produced in U.S.A is extracted from wells which make it oil extracted from land and is therefore required to be transported via pipes which has its own limitations. In U.S.A the crude oil is transported to a state known as Oklahoma which is the only delivery point and to be more specific in a city known as Cushing in Oklahoma. Cushing is the only delivery point for the oils extracted in U.S. which can cause serious shortage of place if oil is not delivered in time.
As oil was being produced at a constant pace with very little demand in the market for oil and with very little storage place available, the quantity of oil available in the market for sale surpassed its demand to a great extent. Before the future contracts expired on Tuesday i.e. 21st April, WTI dropped from approximately 20$ to -37.63$, creating a gap of almost 55%. If we study the entire scenario we can conclude one thing that trading in oil happens only in futures and not in present. Futures trading allows the holder to enter into a contract at a pre-determined price. These futures contracts are then traded in the market by the intermediaries wherein buyers and sellers speculate the prices of oil in near future and make profit on the transaction by quoting prices as per their speculation.
As the entire global situation had terribly reduced the demand for oil, there was already a speculation that the prices will fall as supply was more than demand and this further worsened when the holders of these contracts in order to get rid of the contract in their hand filled the market with contracts thereby causing the prices to further go down.
Many experts, however, allege that USO (United States Oil Funds), the largest oil ETF in U.S.A, caused volatility in oil prices. USO owned 25% of the May futures contract and in a bid to sell of its position flooded the market with Futures contract and ended up manipulating the prices in the market to a large extent.
Brent crude, however, sustained itself and continued trading at positive 20$ per barrel.
The entire turmoil turned the oil markets around the world upside down. Back in India, the futures contract were still trading at 10$ per barrel and the sellers were supposed to receive money for the transaction. However since the closing price for WTI was depicted as – 37.63$ in the NYMEX and the transactions were being squared off in that manner, MCX (Multi Commodity Exchange) in India also decided to settle the transaction at -37.63$. As a result of this the sellers who were supposed to receive some amount were now liable to pay to the buyers.
A week after the fiasco, oil prices are still swinging in uncertainty with the WTI for June futures contract trading at 10$ per barrel. Brent crude for June delivery also settled its position after swinging many times at $20.15.
Economists around the world are of the view that global the economy is likely to take more than a year to recover from this economic slowdown which is worse than the 2008 Financial Crisis. Aviation, tourism, textiles which are the prime sectors generating demand for oil, are the most hit sector. Innuendo the demand for oil, when the pandemic settles down, can be hardly expected to match the erstwhile demand. No doubt that the demand will be more than what it is now but to reach its mark, would be a long run.
If the extant oil prices continue to be constant at the current pace i.e. between 20$-40$, the countries which will be the most benefitted will be the oil importing countries such as India, Japan, Germany and Korea. It is estimated that if India takes the benefit of falling prices, it will assume a profit of $20 million in a financial year. However, the small oil producing countries whose entire economy is dependent upon oil are likely to be the most hit from the falling prices. End consumers are however unlikely to be affected from change in prices.
LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join: