WTI Crude Oil futures plunged 321%

With the Corona pandemic hurting each and every aspect of the global economy in every possible way, Monday witnessed a jaw-dropping moment on when Oil futures started trading a negative price. An important point to note here is that this was the price of a futures contract and not the crude oil itself. West Texas Intermediate (WTI) crude oil futures contract plunged to -$40.32 first time ever in the history of crude oil. So it’s not like that oil companies would pay you to buy oil from them.

As per the Crude oil futures calendar, the May contract was supposed to expire on 21st April. But with the pandemic bringing the economy to a standstill, the American energy companies have run out of space to store it. So, if there’s no place to put the oil, why would anyone want to have a crude oil contract that is about to come due. That’s the reason traders with long positions panicked to get out because of the fear that it would be difficult to find a place to store oil amidst a rising glut of crude. The June contracts are still trading above $20 per barrel. This gap between two near-month contracts was the biggest ever. However if the situation continues to worsen, June contracts can face the same fate near its time to expiry.

Since the beginning of 2020, oil prices have plunged after the combined impact of Coronavirus pandemic and breakdown in the original OPEC+ agreement. There is no end in sight to the economic slowdown, and with producers around the world continuing to pump and traders having no access to storage, oil futures are trading at a fire sale price. The current state of fiasco can be estimated by the following chart which tells us that WTI crude oil prices have plunged below 20 only 3 times(1948, 1998, 2020) in the last 70+ years

Decoding Futures Contracts

Futures Contracts are agreements to buy or sell a particular commodity or an asset at a future date. Each futures contract comes with an expiry date – on this date, the seller has to physically deliver the commodity to the buyer or the holder of the contract. The amount to be paid will be decided based on the market prices on the date of the expiry of the contract.

In terms of crude oil futures, let’s take an example. ‘A’ is a supplier of crude oil and ‘B’ is the buyer. They enter into an agreement to execute the transaction at a future date ‘X’. So on ‘X’, ‘A’ has to deliver crude oil and ‘B’ has to pay the market value of the contract. Each crude oil futures contract is for 1000 barrels and if the value of the contract on ‘X’ is $20 then ‘B’ has to pay $20,000 to ‘A’ and also take the delivery of 1000 barrels of oil.

Buyers of WTI crude oil had to take delivery on April 21 in Cushing, Oklahoma but as demand plunged, there is almost no storage space. So the buyers are rushing to sell their futures contracts to avoid taking delivery of crude oil. This demand and supply mismatch (the basis of pricing) led to a situation when there were only sellers and no buyers resulting in negative prices for futures expiring on 21 April. 

What does this mean for India?

The fall in WTI crude oil futures will not affect the fuel prices in India to a large extent because, India mostly imports Brent Crude which is comparatively stable at $25.34 per barrel. Brent crude price is the international benchmark price used by the Organisation of Petroleum Exporting Countries (OPEC), while WTI crude price is a benchmark for US oil prices. Also, in terms of origination, Brent crude is extracted from the North Sea, WTI is usually extracted from US oil fields in Texas, Louisiana, and North Dakota.

Since India imports primarily from OPEC countries, Brent is the benchmark for oil prices in India. Most of the oil produced in Europe, Africa, and the Middle East are priced according to the cost of Brent crude.

 However, with uncertainty prevailing over reviving industries, further decline in all contracts will help the Indian government to reduce the Current Account Deficit (the difference between the total value of imports and exports). This reduction in CAD will appreciate the value of rupee and reduce inflation.

Why are the oil producers not cutting down the production?

If you have read the article up till now, this question would have definitely popped up to you. Well, let me first give you a little sigh of relief. OPEC and its allies (known as OPEC+) have agreed to cut production by 9.7 million barrels per day. The deal was finalized on April 12 after long discussions that spanned four days. This is the single biggest cut in history. The cut will be reduced to 7.7 million barrels per day from July to the end of 2020 and further reduced to 5.8 million barrels per day from Jan 2021 to April 2022. However since no one has been able to predict anything about economic revival, so there will review meetings to decide any change in plans.

But earlier this year it was reported that the OPEC and non- OPEC allies failed to agree on oil production. But as they say, desperate times call for desperate measures. When the demand dived in so badly then the geopolitical tension had to be kept aside and production cuts decision was taken unanimously. 

It will be interesting to see how the other market reacts to this plunge in prices. I would like to conclude with what Warren Buffet says- “Be fearful when everyone is greedy and be greedy when everyone is fearful.” The current situation offers a good investment opportunity for the long term (1-2 year) investors. So, despite the prices plunging, retail investors have plowed money back into oil futures. The U.S. Oil fund ETF saw a record $552 million on a single day, taking the total inflow to $1.6 billion in the last week. This can be explained by the fact that crude oil futures contracts are allowed for up to nine years in the future. So investors who are bullish on far-term contracts are buying the fear and panic at lower prices. Let’s take a look at the weekly time frame chart of WTI Crude oil futures (January Contract). The rise in volume shows a lot of panic selling by some and penny buying by some. 

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