The Oil In The Pipeline
Bewildered or better yet befuddled or even better blown out of their minds, that was the reaction of people when they heard oil hit negative.
One might wonder how can a commodity price go negative. How can the buyer be paid to purchase oil, I mean if someone paid me to shop, that would be amazing right?
Well, let us try to understand a few things first. I promise to super simplify it for you. This will be in 2 parts. 1st one is the Global oil scenario and the 2nd one is the negative oil price.
Part 1 – Global Oil Scenario.
What is OPEC?
OPEC (Organization of the Petroleum Exporting Countries) is group of oil exporting countries who control the prices by regulating supply and demand. How can they do this? Because this group own’s the majority of world oil reserves and they are the top producers of oil. OPEC was formed way back in 1960. OPEC currently has 13 member countries.
What is OPEC +?
In 2016, OPEC countries and Non-OPEC countries who produced oil joined hands with each other and formed an alliance. And this new alliance was known as OPEC+. The Non-OPEC countries are OPEC Plus countries.
OPEC initially had 14 members who controlled 35% of global oil supply. Now with 10 more members in OPEC+, together they dominate the global oil chart with 55% market share. Most notable members are Russia, Mexico and Kazakhstan. OPEC countries had 82% of world’s oil reserves and OPEC+ countries have 90% of world’s oil reserves.
Why was OPEC+ Formed?
OPEC+ was formed to reorganise the oil market and bring stability to oil prices after the market crash of 2014. And also, to give a direct competition to USA. You might wonder, USA doesn’t have oil reserves, well, it doesn’t have your crude oil reserves, but it has Shale oil reserves. Both oils are usable. The point was the growing competition of US Shale oil. In 2017, USA wore the mantle of the “Top Oil Producer in the world”. Saudi Arabia was 2nd and Russia was 3rd.
Fun Fact – The major difference between crude oil and shale oil is how it is produced. Shale oil is more expensive to produce than crude oil.
Well, everything was fine and dandy till the start of Covid-2019 pandemic. Covid-2019 pandemic caused a slowdown in demand, supply and production all over the world. Suddenly the requirement of oil dropped to an all time low due to no flights, no factories, no transport systems and no production.
So, OPEC Plus’s leading oil producer Saudi Arabia said let us reduce the supply of oil, let us cut down on drilling oil, so that the demand and supply forces act in tandem to keep the price stable.
(ECO 101: More supply, less demand – Prices drop. ECO 102: Less supply, more demand – Prices rise)
However, Russia didn’t think so and refused to make cuts in oil production. Saudi Arabia was furious and it rallied along with OPEC countries to punish Russia for foregoing their OPEC + alliance by ramping up their oil production. They started producing more, however, there was only one problem, there was no requirement.
But why did Russia refuse to reduce oil production, considering it made sense?
Simple, Russia does not like USA. Ever since the shale oil boom, countries had been buying oil from USA. And USA sanctions on Russia haven’t helped. Moreover, the OPEC+ countries have been always ensuring their supply is in line with demand to regulate prices. However, USA doesn’t have to listen to anyone. So, if OPEC cuts its oil supply to increase prices, USA can just increase their production, hence, in a way, establishing USA as a top oil exporter. Hence, causing a belief that USA shale has gathered customers at Russia’s expense. Before OPEC+, Russia was the top single oil producer as Saudi Arabia was a part of OPEC. Russia saw this as the most opportune time to attack USA’s oil industries, as most of oil industries were under massive debt and if oil prices fall, the industry, unless it gets more debt, would suffer a lot and might even collapse. Russia and to say even OPEC wants to curb US oil’s market share.
Getting back, so there is a war, but why would Saudi Arabia actually increase production when there was no requirement. Well, it is believed by analysts that Saudi Arabia also wants the top spot but it can be said that it is price war, a way of arm-twisting Russia to get them agree to their terms. If oil prices goes down, both countries lose. Oil prices have to average at round 45 to 50 dollars per barrel for the countries to make a profit.
Hence, but still, it is the question of the last man standing. Hence, what we can make out from our brief discussion is that, there is a lot of oil being produced, but there is no demand, so what do we do with the oil? Store it. But the only problem is there is not enough storage space.
Do remember this.
Part 2 – The negative oil prices
There are 2 important indexes in the oil world WTI (West Texas Intermediate) and Brent Crude. You can read more about the same from moneycontrol.
WTI is an international benchmark, but it reflects the American market, it is the underlying commodity of the New York Mercantile Exchange's (NYMEX) oil futures contract. Brent crude is more of an international benchmark and is traded on Intercontinental Exchange (ICE).
The WTI hit negative price of $37.63 per barrel. The Brent crude hit $15.98 per barrel, its lowest since 1999, the positive side was that it was positive rather than negative.
The problem is that oil prices are not controlled only by demand or supply, it is also controlled by the futures market. Futures are derivative instruments. Derivatives are instruments which derive their value from an underlying asset. Futures contract are contracts wherein you fix a price and a future date at which you will buy the product.
For Eg: A wheat farmer knows that his wheat produce will be ready in 2 months’ time. He is afraid of price falling, so he wants to secure his price. On the other hand, you might have an FMCG company who produces wheat-based snacks and is afraid of wheat price rising. When both these parties meet, a contract is formed. If today’s wheat price is 30/kg, the wheat farmer may say I will sell wheat at 32/kg in 2 months and if FMCG company agrees to the same, then it will make a deal and will get its delivery of wheat in 2 months.
This same thing can happen with oil. Just replace the wheat farmer with an oil producer and FMCG company with an airline company. But apart from those who genuinely require the commodity, there are others who trade or speculate to make money. Let’s take my example, I don’t want oil, but I see a great opportunity in trading oil futures. I speculate that price will rise, so I buy oil futures and before the expiry of two month’s I sell it off, because if I keep the contract till the end of two months, I might have to take delivery of the same. I do not require the oil. I just want to buy oil at 30/barrel and sell it at 32/barrel before expiry. I would just sell the contract to an airline company who actually requires the oil.
Even equity shares have their futures market. All assets have their futures market. As I said, futures are derivates and derivates derive value from their underlying asset. At expiry of the contract, in case of commodities you take delivery and in case of shares you just pay the futures price in cash. There are 2 types of delivery – cash delivery and physical settlement delivery. In cash delivery you just pay the futures price, so, in case of wheat, I get Rs. 32 instead of wheat, then with that I can buy wheat. In physical settlement, you deliver the wheat to me.
The problem of negative prices occurred as people who brought these futures thought they would sell it at a higher price, however due to coronavirus pandemic, price did not rise at all and as the expiry date of contract neared, it sparked off mass-selling, unless you have space to store the oil, what will you do with the oil? Maybe you can buy storage space to store the oil till the market recovered and then sell it at a higher rate, but the problem was everyone thought of that and soon there was no storage space. Due to shortage of storage space, storage space too became expensive. Just in time inventory is a great concept if you are not a speculator. However, when a large of number of people started selling their contract at a particular point of time, prices took a nosedive resulting into negative prices. Also, we still have to wait for the expiry date of Brent crude which is the last business day of the month to see how it reacts!
Offering investors some solace, the prices bounced backed the very next day into the positive zone.
But the question is how come Brent crude did not go negative?
Do you remember what I said about delivery at expiry, I hope you remembered it, because it ultimately comes to that. WTI is based on physical delivery settlement at expiry, whereas, on the other hand, Brent is based on cash settlement. Instead of physical delivery of oil, you just pay your futures price. No problem of storage space. The point is as you cannot store oil anywhere, you didn’t want it to come to settlement, nonetheless, as no one required oil, no one was ready to buy the futures contract. A transaction can occur only if there are 2 parties and there was no buyer, due to zero demand. If you don’t honour your contract you can be sued, so people were will to pay the buyer in order to get themselves rid of the futures contract. Also, we still have to wait for the expiry date of Brent crude which is the last business day of the month to see how it reacts!
Offering investors some solace, the prices bounced backed the very next day into the positive zone.
Now, the question comes, has it impacted India?
Yes, MCX (India’s commodity exchange) has WTI derived oil futures price. So yeah, Indian investors also lost money on it. In fact, a lot of money, as due to coronavirus pandemic, markets closed early. When the prices hit negative, Indian trades could not exit their positions. The good part is that MCX works on cash-based settlement. It does not have delivery-based settlement. You can read more about it on this article in livemint.
And what about the ongoing price war and increased production in oil by Saudi Arabia?
The production will have to be cut down, considering the lack of demand and storage space. There doesn’t seem to be a way out.
Here we end our story on the oil in the pipeline, however, just something for you to ponder over, how can the price of something go negative, because as per theory it can not.
At spot (present day), futures price converges to spot price i.e. at settlement date, futures price = spot price. That you get from the formula of futures price. The theoretical formula for futures price.
F = S + SRT*100
Where,
F = Futures price
S = Spot price
R = Rate of interest
T = Time period
If you want to calculate 2 months future price, future value is calculated based on current spot price adding rate of interest for time period. As on expiry, there is no time period waiting to elapse for which there will be interest cost, F should be equal to S.
Well, what can you say, reality does have a way of baffling everyone, doesn’t it?
Do let me know your opinions in the comments!!
One might wonder how can a commodity price go negative. How can the buyer be paid to purchase oil, I mean if someone paid me to shop, that would be amazing right?
Well, let us try to understand a few things first. I promise to super simplify it for you. This will be in 2 parts. 1st one is the Global oil scenario and the 2nd one is the negative oil price.
Part 1 – Global Oil Scenario.
What is OPEC?
OPEC (Organization of the Petroleum Exporting Countries) is group of oil exporting countries who control the prices by regulating supply and demand. How can they do this? Because this group own’s the majority of world oil reserves and they are the top producers of oil. OPEC was formed way back in 1960. OPEC currently has 13 member countries.
What is OPEC +?
In 2016, OPEC countries and Non-OPEC countries who produced oil joined hands with each other and formed an alliance. And this new alliance was known as OPEC+. The Non-OPEC countries are OPEC Plus countries.
OPEC initially had 14 members who controlled 35% of global oil supply. Now with 10 more members in OPEC+, together they dominate the global oil chart with 55% market share. Most notable members are Russia, Mexico and Kazakhstan. OPEC countries had 82% of world’s oil reserves and OPEC+ countries have 90% of world’s oil reserves.
Why was OPEC+ Formed?
OPEC+ was formed to reorganise the oil market and bring stability to oil prices after the market crash of 2014. And also, to give a direct competition to USA. You might wonder, USA doesn’t have oil reserves, well, it doesn’t have your crude oil reserves, but it has Shale oil reserves. Both oils are usable. The point was the growing competition of US Shale oil. In 2017, USA wore the mantle of the “Top Oil Producer in the world”. Saudi Arabia was 2nd and Russia was 3rd.
Fun Fact – The major difference between crude oil and shale oil is how it is produced. Shale oil is more expensive to produce than crude oil.
Well, everything was fine and dandy till the start of Covid-2019 pandemic. Covid-2019 pandemic caused a slowdown in demand, supply and production all over the world. Suddenly the requirement of oil dropped to an all time low due to no flights, no factories, no transport systems and no production.
So, OPEC Plus’s leading oil producer Saudi Arabia said let us reduce the supply of oil, let us cut down on drilling oil, so that the demand and supply forces act in tandem to keep the price stable.
(ECO 101: More supply, less demand – Prices drop. ECO 102: Less supply, more demand – Prices rise)
However, Russia didn’t think so and refused to make cuts in oil production. Saudi Arabia was furious and it rallied along with OPEC countries to punish Russia for foregoing their OPEC + alliance by ramping up their oil production. They started producing more, however, there was only one problem, there was no requirement.
But why did Russia refuse to reduce oil production, considering it made sense?
Simple, Russia does not like USA. Ever since the shale oil boom, countries had been buying oil from USA. And USA sanctions on Russia haven’t helped. Moreover, the OPEC+ countries have been always ensuring their supply is in line with demand to regulate prices. However, USA doesn’t have to listen to anyone. So, if OPEC cuts its oil supply to increase prices, USA can just increase their production, hence, in a way, establishing USA as a top oil exporter. Hence, causing a belief that USA shale has gathered customers at Russia’s expense. Before OPEC+, Russia was the top single oil producer as Saudi Arabia was a part of OPEC. Russia saw this as the most opportune time to attack USA’s oil industries, as most of oil industries were under massive debt and if oil prices fall, the industry, unless it gets more debt, would suffer a lot and might even collapse. Russia and to say even OPEC wants to curb US oil’s market share.
Getting back, so there is a war, but why would Saudi Arabia actually increase production when there was no requirement. Well, it is believed by analysts that Saudi Arabia also wants the top spot but it can be said that it is price war, a way of arm-twisting Russia to get them agree to their terms. If oil prices goes down, both countries lose. Oil prices have to average at round 45 to 50 dollars per barrel for the countries to make a profit.
Hence, but still, it is the question of the last man standing. Hence, what we can make out from our brief discussion is that, there is a lot of oil being produced, but there is no demand, so what do we do with the oil? Store it. But the only problem is there is not enough storage space.
Do remember this.
Part 2 – The negative oil prices
There are 2 important indexes in the oil world WTI (West Texas Intermediate) and Brent Crude. You can read more about the same from moneycontrol.
WTI is an international benchmark, but it reflects the American market, it is the underlying commodity of the New York Mercantile Exchange's (NYMEX) oil futures contract. Brent crude is more of an international benchmark and is traded on Intercontinental Exchange (ICE).
The WTI hit negative price of $37.63 per barrel. The Brent crude hit $15.98 per barrel, its lowest since 1999, the positive side was that it was positive rather than negative.
The problem is that oil prices are not controlled only by demand or supply, it is also controlled by the futures market. Futures are derivative instruments. Derivatives are instruments which derive their value from an underlying asset. Futures contract are contracts wherein you fix a price and a future date at which you will buy the product.
For Eg: A wheat farmer knows that his wheat produce will be ready in 2 months’ time. He is afraid of price falling, so he wants to secure his price. On the other hand, you might have an FMCG company who produces wheat-based snacks and is afraid of wheat price rising. When both these parties meet, a contract is formed. If today’s wheat price is 30/kg, the wheat farmer may say I will sell wheat at 32/kg in 2 months and if FMCG company agrees to the same, then it will make a deal and will get its delivery of wheat in 2 months.
This same thing can happen with oil. Just replace the wheat farmer with an oil producer and FMCG company with an airline company. But apart from those who genuinely require the commodity, there are others who trade or speculate to make money. Let’s take my example, I don’t want oil, but I see a great opportunity in trading oil futures. I speculate that price will rise, so I buy oil futures and before the expiry of two month’s I sell it off, because if I keep the contract till the end of two months, I might have to take delivery of the same. I do not require the oil. I just want to buy oil at 30/barrel and sell it at 32/barrel before expiry. I would just sell the contract to an airline company who actually requires the oil.
Even equity shares have their futures market. All assets have their futures market. As I said, futures are derivates and derivates derive value from their underlying asset. At expiry of the contract, in case of commodities you take delivery and in case of shares you just pay the futures price in cash. There are 2 types of delivery – cash delivery and physical settlement delivery. In cash delivery you just pay the futures price, so, in case of wheat, I get Rs. 32 instead of wheat, then with that I can buy wheat. In physical settlement, you deliver the wheat to me.
The problem of negative prices occurred as people who brought these futures thought they would sell it at a higher price, however due to coronavirus pandemic, price did not rise at all and as the expiry date of contract neared, it sparked off mass-selling, unless you have space to store the oil, what will you do with the oil? Maybe you can buy storage space to store the oil till the market recovered and then sell it at a higher rate, but the problem was everyone thought of that and soon there was no storage space. Due to shortage of storage space, storage space too became expensive. Just in time inventory is a great concept if you are not a speculator. However, when a large of number of people started selling their contract at a particular point of time, prices took a nosedive resulting into negative prices. Also, we still have to wait for the expiry date of Brent crude which is the last business day of the month to see how it reacts!
Offering investors some solace, the prices bounced backed the very next day into the positive zone.
Do you remember what I said about delivery at expiry, I hope you remembered it, because it ultimately comes to that. WTI is based on physical delivery settlement at expiry, whereas, on the other hand, Brent is based on cash settlement. Instead of physical delivery of oil, you just pay your futures price. No problem of storage space. The point is as you cannot store oil anywhere, you didn’t want it to come to settlement, nonetheless, as no one required oil, no one was ready to buy the futures contract. A transaction can occur only if there are 2 parties and there was no buyer, due to zero demand. If you don’t honour your contract you can be sued, so people were will to pay the buyer in order to get themselves rid of the futures contract. Also, we still have to wait for the expiry date of Brent crude which is the last business day of the month to see how it reacts!
Offering investors some solace, the prices bounced backed the very next day into the positive zone.
Yes, MCX (India’s commodity exchange) has WTI derived oil futures price. So yeah, Indian investors also lost money on it. In fact, a lot of money, as due to coronavirus pandemic, markets closed early. When the prices hit negative, Indian trades could not exit their positions. The good part is that MCX works on cash-based settlement. It does not have delivery-based settlement. You can read more about it on this article in livemint.
And what about the ongoing price war and increased production in oil by Saudi Arabia?
The production will have to be cut down, considering the lack of demand and storage space. There doesn’t seem to be a way out.
Here we end our story on the oil in the pipeline, however, just something for you to ponder over, how can the price of something go negative, because as per theory it can not.
At spot (present day), futures price converges to spot price i.e. at settlement date, futures price = spot price. That you get from the formula of futures price. The theoretical formula for futures price.
F = S + SRT*100
Where,
F = Futures price
S = Spot price
R = Rate of interest
T = Time period
If you want to calculate 2 months future price, future value is calculated based on current spot price adding rate of interest for time period. As on expiry, there is no time period waiting to elapse for which there will be interest cost, F should be equal to S.
Well, what can you say, reality does have a way of baffling everyone, doesn’t it?
Do let me know your opinions in the comments!!
Very well explained!!
ReplyDeleteThanks a lot for reading!! I am glad you found it well explained!
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