Oil Trades at Lowest Level Ever. What Next?
Updated: May 17, 2020
Oil contracts took a huge tumble Monday, April 20th, dropping down to -$37.63 i.e., sellers are willing to pay $37.63 to buyers in the hopes that those buyers will buy their contracts. It is crucial to bear in mind, however, that this does not mean oil as a commodity was sold in the negatives – it was merely the April-expired future contracts being traded in negatives. Here's a quick explanation of how oil trading works.
When one trades in oil, they're buying and selling something we refer to as oil futures, contracts that state that the person holding the future will take delivery of a certain amount of oil. This means that oil markets can often function similarly to stock markets in the sense that traders can make profits of the fluctuations in oil futures by buying low and selling high without ever having to take possession of the oil in the first place. These contracts all have expiration dates, and when this expiration date arrives, it means that the person holding the contract HAS to take delivery of the oil. This delivery isn't some small ordeal, as there are always a few conditions attached. First, the minimum amount for a contract is 1000 barrels. Second, the buyer has to arrange for the oil to be received from the seller's pipelines (mostly in Oklahoma) and provide not only the container for transport but also a government-approved storage facility. What happened on Monday was that traders could not find corporations and buyers for oil contracts, simply because nobody required oil with the economy at a standstill. Because nobody needed oil, the companies that typically buy oil contracts to cash in for the actual commodity – oil storage and oil pipeline companies – were nearly filled up. Now while the news of negative oil prices isn't as dire as people are portraying it to be, it is unprecedented and causes for concern. While June futures are still trading at around $20 a barrel and December futures go as high as $32 a barrel (which is still relatively low when compared to average prices in the past), if this pandemic doesn't end soon, and demand for oil remains as low as it is right now, there is nothing to prevent something similar happening to future contracts too as the country runs out of storage for the oil. According to the Economic Times, the world has an estimated storage capacity for 6.8 billion barrels, and almost 60% of it is filled up. The critical storage hub for US oil is in Cushing, Oklahoma. It has a capacity for 80 million barrels of oil, but as of right now, it can only hold 21 million more. This is startling news, given that the US generally imports 10 million barrels of oil per day. Admittedly, it has been exporting 7.5 million barrels per day since mid-2018, but everything has come to a standstill because of COVID-19. So, the country has its storages consistently filling up, and no outlet for its stockpile. Russia and OPEC have already pledged substantial cuts to oil production (a welcome announcement considering their oil war is a significant reason for this drop in prices), and US oil production is expected to be cut from 13.3 million barrels per day to less than 11 million barrels – a truly historic cut in production.
The question that needs to be asked, however, are the implications of this fall in oil contract prices. Firstly, mass unemployment. With the demand for oil falling rapidly, and to this extent, many small oil companies will not be able to sustain. The US oil and natural gas industry support 9.8 million jobs, nearly 5.6% of total US employment. With the entire industry failing as a result of a complete lack of demand, experts predict a loss of more than 2 million jobs within the industry by the end of 2020. This is grim news if you couple it with a projected economic contraction of 4.1% this year. Other industries will reap the benefits of excess oil once this lockdown is lifted, as the price of petroleum and natural gas will be at an astonishingly low-level. But the oil industry is in a grave state right now, which will only be worsened if the lockdown isn't lifted sooner. If the lockdown continues until June 19th (the expiry date for the next series of oil contracts) many oil companies will be forced to shut down, which could plunge the economy down further. In addition to this, investors' confidence takes a huge hit. The DJIA has dropped by 585 points as the market became exceedingly bearish. NIFTY has fallen below 9000 points, falling 300 points since the crash of the prices of oil contracts. Even Asian markets, who had managed to still have some strength towards their demand for oil are seeing heavy falls now. While a country like India, who imports most of its oil, might see a positive here in the short run for its budget, the fact that countries like Russia and the United States are facing such low prices for some of their most significant exports means that demand for Indian exports might dip soon too as countries rush to find ways to balance their budget. Hopefully, we should see markets return to normal as the curve begins to flatten (there might even be an increase in regular oil consumption due to contracts being held for oil at lower prices than before). While recovery won't be instantaneous, it is not impossible.
Authors : Aviral Dhamija, Akhil Vajjhala