April 20, 2020, to be marked as “Black Monday” in Oil-market history

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April 20, 2020, to be marked as “Black Monday” in Oil-market history

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 April 20, 2020, to be marked as “Black Monday” in Oil-market history

In the history of oil market April 20, 2020, will be marked as "Black Monday", as, on that very fateful day, the US WTI Crude Futures Contract price fell below zero and charted a negative zone for the first time. The Future contract of WTI Crude Oil for May delivery fell below zero and traded to a record low of -$40/bbl on the New York Mercantile Exchange (NYMEX).

On Black Monday, WTI May delivery contract started the session at $17/bbl, and while most of the contracts which had to be carried over to June’20 series had already been made, which left a very little liquidity for traders to square-off their open position. As the trading day started progressing, the price of May contract kept on diving lower, which implied that the premium one had to pay to roll over his contract to June became expensive. The remaining holders of May contract rushed to get rid of the May contract at any price; otherwise, they would have to take delivery of the contract.

Let’s understand the futures contract first- A futures contract is a contract to buy an underlying commodity or security on a predetermined future date, at a pre-established price and for a quantity agreed upon. It is a financial tool designed for the purpose of hedging, speculating and arbitrage.

What does a negative contract price stand for?

WTI Crude Futures Prices for Delivery in May 2020. (Source: Thomson Reuters)

A negative oil price contract means those who had WTI Crude Futures for May delivery were ready to pay someone $40/bbl to take them out of the contract. It means that if you were to buy those contracts ", you would get $40/bbl for buying it". This had never happened before that one who will buy an oil contract will also get paid for his action. Earlier, there were instances of dairy farmers, when they had an excess of milk which surpassed demand significantly, they just used to dump their milk down in the drain but was never experienced this in the case of oil.

Even though the WTI Crude May Future contract prices turned negative, hardly any buyer came out to take the delivery. The general perception with regards to the oil futures market is that only oil companies (upstream, downstream, and integrated) or those whose business depends upon crude derivatives participate in the oil futures market, but there are a massive number of orders placed by speculators and arbitragers, they go long or short as per their analysis, but they just can’t take the delivery at all. They settle their position for cash and not by taking delivery. So, here is classic case noted in the commodity futures market, as a speculator or arbitrager you would have got paid for going long on WTI Crude May Futures contract, but the question is how they could take the delivery, what they are going to do with barrels of oil and more important where they are going to store that?

So, those who are thinking that why didn’t anyone bought the WTI Crude May contract even though they would have got paid for buying that contract, it is because participants in the oil futures market include hedgers (those who are exposed to volatility in the oil prices), speculators (those who want to speculate or bet on either side for gain) and then there are arbitragers as well (those who think there is price mismatch between spot market and futures market and want to buck the trend). Speculators and Arbitragers cannot take the delivery because they are not into the business of oil, they don’t have a storage facility to store oil and sell it in future, they just want to participate in the futures market to benefit from the trend.

But things went heavily wrong for speculators and arbitragers on April 20, 2020, despite that, they were ready to pay people who can rescue them from taking delivery of oil.

Now the next question is, why didn’t oil marketing companies and oil storage service providers bailed out speculators and arbitragers in WTI Crude May Futures contract?

Because of oil supply glut due to a) COVID-19 pandemic, which has hit hard on demand for oil and b) recent oil price war between Saudi and Russia, in which the latter refused for oil production cut deal extended by Saudi Arabia. Storage tanks have already chocked up globally in the face of dried demand for oil, and they don’t have further headroom to store an additional quantity of oil.

And still Saudi Arabia, Russia and others are producing much more oil than the market can consume. Generally, in a normal cycle, if supply surpasses demand, excess of oil goes into the storage tanks. But at present, the market is overwhelmed with supply glut and overproduction has gone so long, which has left no space for further storage of oil. And the result was, suddenly, the most valuable commodity on the planet got dumped for free in the futures market.

How did WTI Crude May Future Contract prices enter the negative territory?

In economics, we have heard of a term called “Inelasticity” in Demand & Supply. The same phenomena turned true for WTI May Future Contract. As demand for WTI May Futures Contract was not coming out, regardless the prices moved lower and entered the uncharted territory, while at the same time supply was increasing. This permitted oil prices to enter the negative territory for the first time ever in history. In an inelastic market situation, the prices can slip into negative territory, and the seller has to pay the buyer to take the delivery.

It is quite expensive for oil producers to suddenly stop the production; therefore, many are throwing crude output for the time being, even at a loss.

However, it seemed unrealistic that oil could ever be available at free (rather would be paid for purchase) with its characteristics of one of the most valuable commodities on the earth or prices could turn negative no one would have any idea about this. But the whole development taught a lesson to the world that in an auction market prices of a commodity regardless how much valuable it is, could slip int the negative price zone, if there is supply glut for it, with waning demand.

In a general equilibrium market system, where demand and supply forces are left free to decide the price of a commodity, it can lead to prices of commodity negative as well.

Is recent production cut announced by OPEC+ cartel not enough to establish the Oil prices?

On April 12, 2020, the world's energy superpowers negotiated an oil production cut deal to prop up oil prices. The OPEC and its allies like Russia, together known as OPEC+ decided to reduce oil production by 9.7m bbl/day from May 2020 to end of June 2020, in the wake muted oil demand globally, which emerged because of the novel virus outbreak. It was the biggest ever production cut agreed upon and accounted for 10% of the world’s normal supply of the oil.

However, amid this pandemic, the demand for oil tumbled by ~ 29m bbl/day, which implies three times of production cut agreement. And hence demand uncertainty is still up in the sky and no one knows when it is going to pick up further.

So, pain in the oil market is a little longer than people are estimating and oil trading in the futures market is also turning to be very risky amid uncertain times.

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