Negative oil prices - 101
I used to track oil prices everyday while at Goldman Sachs (way back in 2016-17). Will use some of the gyaan I picked up there to explain why crude oil prices fell below $0 yesterday (20-Apr-2020) in simple terms and also cover few other points around crude prices.
First, oil prices didn’t fall below $0 globally. It happened only in US. Although it might touch zero globally based on few factors I will explain later. There are 2 indices that are used as benchmarks to price oil worldwide – WTI and Brent.
WTI is used to price oil extracted in US. And Brent is used for oil extracted in Europe, Middle East and Africa – hence making it more global (Brent dictates oil prices for ~2/3rds of global oil supply).
It was WTI that went below $0. Brent is still trading around $20.
Great, but why do they trade at different prices? Firstly because quality of oil is different. WTI is ‘lighter’ & ‘sweeter’ than Brent oil. ‘Lighter’ is preferred to ‘heavier’ because it is cheaper to refine. ‘Sweeter’ is preferred to ‘sour’ because it produces lesser sulphur residue (think of it as bad undesirable residue). So ideally, WTI should trade at a slightly higher price than Brent. It used to actually, until Brent became costlier around 2011 or so.
This get us to the second reason why they trade at different prices – because supply & demand vary in their respective regions. These changes in supply & demand can be driven by geopolitical events, production levels, etc. In 2011, with arab spring on, there was fear of the Suez canal being closed. Suez canal is an important route for transporting oil across africa, europe & mid-east. This bumped up Brent prices over WTI. Another example – When US producers discovered a new style of extracting oil called ‘fracking’, they produced too much and WTI prices fell.
So coming back to why WTI went below $0.
When price is at $30/barrel, I receive $30 when I sell a barrel. When price is at -$10/barrel, I pay $10 when I sell a barrel. Now, why will I sell? Can’t I just wait till prices rises and then sell?
The problem is some people have to sell regardless of the price. They will lose more if they don’t sell because they have will have to take delivery of the oil they bought and find storage for it.
Wait, what’s all this? Time for us to understand how oil futures work.
An ‘oil future’ is a contract I enter into today (say, April 20) where I promise to buy oil at a certain pre-decided price in the future (say, June 20).
Why would someone do that? To bring in some certainty around how much they will have to spend on oil. Say I’m a manf. who buys oil for my factory. I can lock in price of $30 today for my oil purchase 2 months later. 2 months later, I’ll pay $30 (regardless of whether actual price is higher or lower) and take delivery of it, ie, actual oil will move from seller to me (buyer).
I prefer it this way because my future expenses are more certain and I can plan accordingly. But then there are few people who don’t need oil. They just want to make a bet on the oil price and make some money off that (“Speculative traders”).
If a speculative trader entered into a oil futures contract of 2 months at $30, 2 months later – he/she will just sell the contract to someone who actually needs oil at current price. If current price is $35, he/she will pocket profit of $5. If the price is $25, they’ll pocket a loss of $5. The speculative trader doesn’t actually take delivery of any oil.
So a smarty trader (let’s call him ‘Bala’) bought WTI oil futures in Dec 2019 with a promise to buy oil at say, $30 in Apr 2020. D-day arrived and price of oil was way below $30 because of lower demand due to Covid-19.
Since Bala doesn’t have an intention of really buying oil, he has to sell the contract on D-day, even at a loss. Or he will be charged something called ‘storage fees’ by the commodity exchange and that will increase his loss.
The problem was…no one who could actually take delivery of that oil in the US was willing to buy – either because they were shut down or they had reached full storage capacity. But Bala had to sell. He was willing to give the oil away for free ($0) but still no one bought.
Finally, Bala said “I will pay $40 to whoever take delivery of my oil”. Someone agreed to buy and WTI index recorded a negative price for the first time in history. Bala also saved himself by limiting his loss to $70 ($30 + $40). He’d have been worse off had he held on.
Coming to Brent.
Brent hasn’t touch zero or sub-zero levels because there are few people with empty storage in Europe, middle east, etc who are still buying. Once they start touching 100% capacity, we can possible see even Brent touch $0 or below. If some parts of the economy kickstart and demand for oil picks up before those people reach 100% capacity, then Brent might not head towards such unreal prices.
Just FYI, India buys oil from OPEC (a group of oil producing nations) which price their oil based on Brent. Okay bye. This thread got too long. Sorry for wasting your time
I published this post first as a Twitter thread here.