Crude collapse and the price disconnect

On April 20, the West Texas Intermediate (WTI) crude futures, the benchmark of America’s oil industry, for the month of May plunged to a negative $37.63 per barrel (bbl) on the New York Mercantile Exchange — a fall of more than $55 per bbl. The last time the US crude averaged less than $10 a bbl was in 1974. The Brent crude futures, on the other hand, did not fall so much on the same day. It is true that crude oil prices globally are under pressure due to excess supply and poor demand, thanks to the Covid-19 pandemic. 

The Brent crude futures for the near month did fall in the last two days and closed at below $16 a bbl on Wednesday — its lowest since 1999. However, it is still in the positive territory. In this context, two questions seem to be blowing in the wind: (a) why did WTI crude turn negative, and (b) why are we not seeing a fall in petrol and diesel prices at pumps in India?

A negative price by itself seems to be an anathema. After all, Price Theory 101 tells us that market price being determined by equality of demand and supply at the worst can be zero, thereby making the market come to a halt. Does a negative price mean that oil producers will pay whosoever would like to pick the oil? It is here that the distinction between spot and futures market is important. While the spot price refers to the current quote for immediate purchase, payment, and delivery of crude oil, its futures price is an offer for a financial transaction that will occur on a later date. Simplistically, oil is not sold at a negative price. In particular, while the WTI spot price too has experienced a sharp fall, currently oil is still little above $10. 

Why did WTI crude futures expiring in May turn negative? This was not the case with mid and far month contracts. The WTI crude June futures was trading at $21 and the July contracts at $27 on the same day. Three reasons may be put forward for such a sharp reaction to the near month crude futures prices. 

 
First, the classical demand-supply mismatch could explain it partly. A lack of demand for oil led to massive inventory build-up for the American energy companies, mainly shale oil producers, and they are running out of storage space. Also, these oil producers are unable to cut down the production in the short run (like coal-fired power generators) and, therefore, are willing to give the oil free to anyone who wants to take delivery and free up the storage space. 

Second, there is a fundamental difference in the nature of Brent crude futures and WTI crude futures contracts. Brent crude futures are cash-settled whereas WTI crude futures are settled physically. It implies that any trader who is long (holding buy position) on a futures contract, when it stops trading, will have to take delivery. Therefore, that trader will have to close out the position before the trading on the contract stops if she does not want to take delivery of the physical oil. The WTI crude May futures contract stopped trading on April 21, which means it entered into delivery period. 

 
Third, a quarter of the WTI crude May futures contracts were held (long position) by an exchange traded commodity fund called the United States Oil Fund. The fund was speculating on the rebound of oil prices when it was reported that the negotiations with the US and other oil producing countries were fruitful and there was a possibility of a massive cut in oil production. That did not happen and the fund began selling May contracts well before April 21, replacing them with June and July contracts. 

Thus, crude oil in the current world is unlike a grocery item and its price dynamics go beyond its demand and supply. Extent of financialisation seems to have an important bearing on its price. In fact, the experience of crude oil price during the global financial crisis of 2008-2009 may drive home this point. WTI price experienced a roller coaster dive and gyrated between $134 in June 2008, $39 in June 2009, and $84 in April 2010. Seen from this perspective, the current fall in WTI price may not seem to be that unusual. 

There is, however, another angle to this negative futures price. The depressed price could be an early indication of market players’ future expectations. Given that the International Monetary Fund in its April 2020 release of the placed its global growth projection in 2020 to be (-) 3 per cent, the dramatic fall in crude prices is perhaps in sync with that dark reality. 

Why are we not witnessing a similar fall in prices in India? Four possible reasons may be cited. First, Indian oil refiners have about two months of crude inventory and hence would suffer a massive inventory loss if the product prices fall sharply. Holding on to the current price will help state-run oil retailers to make up for past losses. Second, government, both at the Centre and states, would like to shore up oil tax revenue. While the crude oil prices were falling glo­bally for more than two months (Brent crude has plunged 66 per cent this year), the retail petrol and diesel prices in India have fallen by only 8 per cent during this year so far. In fact, the prices did not cha­nge for more than a month now. On top of it, as crude price was falling, the central government increased excise duty by Rs 3 a litre — the biggest jump in four years. Third, the rupee has depreciated about 8 per cent this year against the dollar. So, any reduction in global crude price is partially offset by adverse rupee movement. Fourth, Indian oil retailers, under the present deregulated environment, revise their product prices based on a 15-day average. Hence, the recent sharp fall in the WTI crude price would not have immediate effect on product prices at petrol pumps. 

In these disturbing times, thus, the trend in crude oil price is perhaps reinforcing the sense of despair in global markets. While the depressed crude prices globally may start to reflect in India in due course, its temporary disconnect is perfectly explicable. 
The writers are professors at Indian Institute of Management Calcutta


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