Let’s Be Guided: the Price of Oil turns Negative?

As it stands now, crude oil itself has not turned negative. However, the contract for future delivery (ie, Oil derivative) precisely May contract which is due to expire today, that has gone negative. However, contracts expiring in the distant future are still positive. The contract price is basically determined by the price of oil commodity, the convenience yield and the cost of storage. Buyers mostly enter into a contract with oil producers to supply them with oil in the future. However, with the world at a standstill, demand has basically dried up. Yet, oil producers are still lifting oil off the ground. Hence, oil supply far outstrips demand. The price of storage is now higher than the price of the oil itself. The convenience yield is basically the benefit derived from holding the oil commodity. However, it seems at this time, the convenience yield is almost negligible. These explains the reason for the negative oil price.

At the moment, only WTI Crude (benchmark oil produced in the US) has turned negative due mainly to the high cost of storage relative to the price of the oil. Storage cost are now high due to the overwhelming supply glut. Oil storage capacities are running out. Therefore, it now cost more to store the oil. And the economic value of oil has now dropped significantly. And since it’s a futures contract, it’s physical delivery is in the future. And at the moment, the storage cost has gone up due to shortage of storage space.

Traders who entered into a May futures contract by going long are due to take physical delivery since the May contract expires today. Once, it’s a contract, you have to take delivery when the contract expires unless you are able to resell to another party. But with world economy in lockdown, the major oil consumers are demanding less oil. However, traders are also looking for avenues to offload the oil instead of taking possession. This is mainly because price of storage has gone up. So traders/buyers would rather sell than take delivery and incurring high storage cost. Technically, a trader would rather pay someone to take the oil rather than take delivery and incur the high storage cost.

However, the price of Brent Crude, another major oil benchmark used in Europe and most part of the world, is still positive due mainly to available storage capacity. However, if things do not improve, analysts are predicting a similar fate for Brent crude for future contracts.

To resolve this issue, oil producers must consider shutting down operations or cutting production significantly. However, there are dire consequences as well. These oil gurus have huge debts on the books and financial obligations to fulfill as well. It’s likely some of the these oil producers might require government’s financial assistance in future. Till then, let’s see how things unfold.

Let’s be guided therefore, crude oil still has a value!

* This brief write up represents my views only and does not represent the views of any organization or individual.

Please drop your comments/suggestions, let’s learn together.