Oil Price Crash: Do I Get Gas For Free?

Last night my twitter was flooded with news of oil prices collapsing to a sub-zero level, this was apparently something that hadn’t ever happened in the history of the oil industry, and therefore the social media went insane claiming that such an incident would indeed collapse the economy and render everyone jobless.

At the first glance, I thought this was absolutely inconceivable, why would producers sell something as valuable as oil for practically free? However, after hours of research, it all started making sense.

First of all, it is imperative to understand that it is not the oil prices that went sub-zero, but US oil “futures” for May 2020 that unforgivingly plummeted to negative figures. While oil prices are declining worldwide, they never went below zero.(or even near zero for that matter)

For starters, oil is one of the most sought after commodities in the world (at least it was), and is actively traded through online exchanges just like shares. Oil trading contracts are referred to as “futures”, basically meaning that buyers and sellers agree to buy or sell the commodity in advance anticipating a favorable future price. The price of these contracts fluctuates constantly based on supply and demand so the final price is determined on their expiration date. Futures usually have a one month settlement period, and before the settlement date, the buyer can either sell his contract through the exchange or take physical delivery of these oil barrels at a specified future date at the determined price. It is also important to note that these contracts are usually traded one month prior to delivery dates, for example, a future with delivery in May will be settled in April. Thus, alongside demand, supply, and geopolitical forces, trading also plays a major influence in determining oil prices.

Oil prices are reflected through various indices, the most prominent ones being Brent Crude (oil extracted from the North Sea) and WTI ( oil extracted from US oil fields in Texas, Louisiana, and North Dakota). While Brent crude is the international benchmark used by OPEC, WTI is the US benchmark of oil prices.

Clarification with an example

To explain this concept let us take an example. Mr.X logs onto the exchange, WTI future for June is trading at $60 per barrel, Mr.X anticipates that the price will increase within the month due to some geopolitical tension and he buys the contract. Before the settlement date, the price surges to $100 per barrel, Mr.X now sells his contract profiting $40 per barrel. However, if the price was to fall to $20 Mr. X would have faced a loss of $40 per barrel had he sold his contract. This is scenario A.

Scenario A is most likely to be faced by speculators and traders who have no intention of buying the commodity and simply plan to profit out of its volatile market.

In Scenario B Mr.X holds onto his contract till settlement date, he is now legally entitled to take delivery of the commodity at $ 60 per barrel as opposed to the running market price of $100 per barrel, he benefits from the contract by paying in advance. However, If the price was to fall to $20 per barrel and Mr.x still held onto the contract, he would have had to pay $60 per barrel on the delivery date as opposed to the market price of $20.

Scenario B is most likely to be faced by an industrialist who plans to secure the commodity at a fair price for production purposes, helping him maintain the stability of expenditure and revenue despite market volatility.

So with the basics in place, let’s briefly discuss about the forces of demand and supply.

Recently, a deal between Russia and OPEC to cut oil production and stabilize the plummeting global oil prices failed, leading to a further decline in oil prices. With practically no production cuts in place worldwide, oil production is moving towards a state of excess supply.

Due to the COVID-19 pandemic, subsequent lockdowns, and slowing down of economies the global demand for oil is slowing collapsing. With the demand of oil dropping by around 20% in April 2020, many oil-reliant economies might soon face serious financial tensions. However, to meet with these changes in demand countries aren’t simply willing to cut production, this is because stalling oil production has serious costs associated with it. Therefore, in some cases producing oil is simply better than halting the industry, even if the international prices are unprofitably low.

The intermingling of excess supply and awfully low demand is now filling up crude storage units across the globe at an alarming rate. Lack of storage units and high costs associated with crude storage is another reason why people are reluctant to invest any money in the commodity which now faces an uncertain future.

So what actually happened to oil price indices?

Early morning on April 20 the WTI benchmark crashed 300% from around USD 20.55 per barrel to USD (-)40 per barrel for the contracts which were due to be settled on April 21. Plummeting demand, practically no use, and lack of storage space for the commodity lead to excessive selling on the exchanges because no individual wanted to take delivery of the stressed commodity. The index soon nosedived into the sub-zero level. This theoretically meant that the contract holders/producers were actually paying buyers USD 40 to get rid of their oil contracts and avoid delivery. This seems outrageous but the extremity of market forces of supply and demand has made such an abnormality possible. It is also safe to claim that the economic impact of COVID-19 and previous failed oil agreements have “fueled” the market forces to such limits that a catastrophic crash like this was bound to happen.

With crude piling up and no place to store it, global oil indices started plummeting. The worst-hit being the WTI Index reflecting USA’s struggle to manage its oil stockpile. The Brent Crude index fell relatively less at around 6-7% to USD 25 per barrel. This is simply because the Brent Index is an international index representing the international condition of oil supply and storage which apparently, isn’t as severe as USA’s condition.

Reiterating, it is the May WTI Futures which fell to USD (-)40 per barrel (and have since rebounded), and not crude itself. However, it’s still appalling that 1 oil future is now worth less than a can of coke. Events like these are testimony to the fact that the “economically strong” world is unprepared against unforeseen challenges like COVID-19. To the overly optimistic people out there dreaming of free gas, I’m sorry for shattering your dreams.