Global Crude Oil Fiasco: Reason of Fall | Facts | Conclusion

• 24 April 2020 | 1055 Views | By Abhinav Mishra

It has been a season of surprising swings in the global economy, the mood swinging mostly around COVID-19 news but nothing compares to the plummeting value of global crude oil prices. Crude oil prices have been in the news for the past few days.

Before we start, it is important to know about benchmarks in oil pricing. There are mainly three benchmarks in oil pricing, WTI, Dubai Crude and Brent. In this article, we are going to talk about WTI. Western Texas Intermediate is extracted from oil fields in the United States of America. The main areas where it is extracted are Texas, Louisiana, and North Dakota. From there it is transported via pipeline to Cushing and from there it goes to Oklahoma for delivery. Cushing was one of the most important spots for oil for decades and has also been the delivery spot of contract and price settlements for WTI for more than 30 years. The futures contracts are listed on the New York Mercantile Exchange, popularly known as NYMEX.

How Crude Oil prices are Regulated and calculated?

World oil is not bought and sold directly. The oil is traded through contracts. Just like shares, oil futures contracts are also traded on futures exchanges. These contracts are a legal agreement between sellers and buyers that bind them to receive and buy a certain quantity of oil when the contract expires.

Many wonder why oil prices change daily? It is because oil prices are controlled by traders who bid on oil futures contracts in the commodities market. These traders are registered with the Commodities Futures Trading Commission. Commodities have been traded for more than 100 years. The CFTC has regulated them since the 1920s.

History of Crude Oil Crash

Before we get to the current crude oil crash, you should know about two more crude oil crashes from the past.

1973 Oil Crash

In October 1973 when the members of the Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo, it led to the 1973 oil crisis.

During the year 1969, American domestic output of oil could not keep pace with ever-increasing oil demand and the trend continued in the following years. In 1973, US oil production had declined to 16.5% of global output. Despite the US tariff on oil imports, the costs of producing oil in the Middle East were low enough that companies could turn a profit. This hurt domestic oil producers in places like Texas and Oklahoma who had been selling oil at tariff-supported prices and now had to compete with cheap oil from the Persian Gulf region.

The Organization of the Petroleum Exporting Countries (OPEC), was founded by five oil-producing countries at a Baghdad conference on September 14, 1960. The five founding members of OPEC were Venezuela, Iraq, Saudi Arabia, Iran, and Kuwait. After the oil companies slashed the posted price of oil, OPEC was organized but the posted price of oil remained consistently higher than the market price of oil between 1961 and 1972.

After knowing interesting sequence of events above, we can answer

Who controls oil prices in the world?

The oil embargo gave OPEC new power to achieve its goal of keeping prices stable and managing the world’s oil supply. OPEC tries to stabilize the price of oil by raising and lowering supply. They would sell their finite commodity too cheap if the price drops too low. If the price was too high, the development of shale oil would look attractive.

Metallgesellschaft(MG) 

A classic example in the risk management, MG incident raised several questions and doubts on smart trading. It was a German industrial conglomerate that opened an energy trading office in the US in the early 90s. Their idea was to

• sell refined products in the physical market
• to produce the products invest in refining capacity
• to hedge the forward sales through financial derivatives.

In the year 1992, when this strategy was implemented the current physical prices were lower than the future prices. As a result of which the sales contracts were set at a higher future price. This meant that purchasing the “near” month future contract was more sensible and profitable. MG strategy was to cover the long-term, fixed-price sales by buying contracts in the near months. As each month rolled off, they bought contracts in the next month. Their plan was to continue this process until the time physical product sales contracts expired in 10 years. This strategy would only work if the future market was backward-dated meaning each successive month is lower than the prior month.

This was not a perfect approach and it had a flaw – It was the volume of contracts being traded every month since they were loading up on closer month contracts. The other issue was that they were not getting paid for the product sales for years out and they began to run out of cash. Their position by the fall of 1993 was estimated between 160 to 180 million barrels stretched out over the following 10 years.

Price fell in 1993 when the market received a bearish signal from OPEC on the quantity of production. This changed the game, this lowered the future prices and reversed the market from backward-dated to contango(in which each successive month’s price is higher than the prior one). A new MG team was appointed to handle the new scenario, still, it resulted in losses on the future purchases of about $1.5 billion. They had to seek bailout funds from one of their banks and also had to sell off several divisions. Today, the MG giant no longer exists, having been bought out by a competitor.

Why Crude Oil prices are falling today?

Crude oil prices are back in the news as the West Texas Intermediate oil(WTI) futures expiring in May went negative to close at -$37.63 which has never happened before. 

How does the future work in crude oil?

Once the month rolls and if you haven’t closed out your positions, you’re expected to go to delivery, and if you’re not involved in the physical market and have no means to take or make delivery, you get caught at the whim of those who trade in both the financial and physical markets, and that’s what caused the negative pricing.

What do you mean by Negative Pricing of Crude Oil

You must be wondering what negative oil price means. If it was 0, it was still understandable, right? So a negative oil price means the major oil producers will pay buyers to take oil off their hands. The reason is very obvious, the demand for crude oil is going down amid the coronavirus pandemic and the generation can’t be stopped.

The oil extraction is a huge, ongoing, and expensive process and the machineries can’t be stopped. Stopping and resuming it later is going to cost a huge amount to the companies, as a result, they are happy to keep on extracting the oil and get buyers to store the oil. The US will likely continue to add oil to its strategic reserves in 2020, but it is accepted now that it is running out of space and can probably only sustain daily additions of 300,000 barrels for the rest of the year.

The major consumer of crude oil is the airline industry and most of the airline companies of the world are at standstill and hence for the first time in history, the demand is far less than the supply. The United States was producing about 13 million barrels a day before the transportation industry came to a standstill along with airlines. Even the Americans began to stay home after the 3rd week of March. American drivers are responsible for about 10% of global oil demand, and in the current scenario, their use of gasoline has been cut in half.

Refining companies have already cut back the production by 25% and still, they have scope to pull back even more. The maximum they can hold back is to produce 60% of the capacity. They are under pressure to reduce production.

What does the Current Situation mean for Oil Companies?

$30 was already quite bad, but once the price gets to $20 or even $10, it’s a complete nightmare. Currently US crude for June delivery is trading above $20 a barrel. When the time was good, a lot of oil companies would have taken huge debts and most of them won’t be able to survive this historic downturn. As per experts, if oil continues to trade at $20 level, 500+ US oil production and exploration companies will file for bankruptcy by the end of 2021. If the prices go further down, for example at $10, there would be more than 1100 companies filing for bankruptcy.

What does it mean for consumers?

If people are thinking the crash in crude futures will bring the prices down at the gas pump drastically, then they are wrong. The gasoline and diesel prices will continue to go lower but it won’t be given away as most are thinking because companies are not able to store the oil. However, consumers will definitely save on their fuel expenditure in the coming months.

What does it mean for airlines?

Airlines which are already cash-strapped, the decline in crude prices will make it cheaper to operate flights that are already nearly empty as people are in lockdown due to the coronavirus.

The fall in crude futures is also indicative of the fact that the market does not expect airlines to add back many flights to their slimmed down networks any time soon.

Which sectors in India may benefit with falling crude oil price?

The direct answer is – None. India will not benefit from the fall and petrol and diesel prices will not go down any time soon. The Indian Basket – a weighted average of Oman, Dubai, Brent Crude – is an indicator of the price of Indian crude oil imports. The crude oil is currently at $20.56 per barrel, sharply lower than levels seen before. As the entire nation is under lockdown, there is hardly any demand for oil as India already has its tank full and it refrains India from buying any oil. 

The rupee is currently trading at around 76 per US dollar. Though India can buy oil at a reduced price but weaker currency will ensure that it spends comparatively more. The global lockdown has already stretched and if it continues for a few more months, global oil producers could be left in a pool of trouble.

The future

The COVID-19 situation is too early to predict and global experts believe it will take a long time to burn off so much crude and this will create a looping demand-supply issue for a longer period. What the energy market is telling us that demand isn’t coming back any time soon, and there’s a supply glut.