S Murlidharan

Why oil futures are in the negative territory

S Murlidharan | Updated on April 21, 2020 Published on April 21, 2020

Excess oil sans storage capacity in Gulf nations, plus the compulsions of futures trading, resulted in the rather baffling denouement of negative prices

On April 20, 2020 crude oil plunged to an all time low — US benchmark West Texas Intermediate (WTI) crude price for May delivery crashed more than 300 per cent, deep into negative territory, touching -$40.32 before clawing back to settle at -$37.63. April 21 is the last day to trade for May 2020 WTI on the New York Mercantile Exchange (NYMEX), and hence there was a frenzied attempt to maximise profits by bears and minimise losses by bulls. The WTI for June delivery held above $21 a barrel on Monday, indicating that things could hopefully turn for the better if Covid-19’s grip on the humankind slackens. Brent crude, the global benchmark for spot oil, traded around $26 a barrel, showing that oil wasn’t available gratis yet.

Indeed, it was the quirks of the derivatives market playing out in full towards the end of the month that resulted in the negative price. The US market is even more vulnerable, because of its huge shale gas production. The pulls and pressures of oil from the Gulf nations vis-à-vis those from the domestic shale gas producers, plus the compulsions of futures trading, resulted in the rather baffling denouement of negative prices. Futures trading for a given period has to be settled at the end of its tenure. The negative price picturesquely describes the situation, wherein oil extracting industry could well have to pay for getting its excess production taken away in the absence of storage.

Oil extraction, like any continuous-process industry, cannot be shut down unless there’s a huge restarting cost. Hence the emphasis on production cuts. US President Donald Trump personally brokered a truce between Saudi Arabia-led OPEC and Russia on April 12, 2020, so as to cut production of 9.7 million barrels a day. The US President has his domestic constituency to reckon with. Shale gas producers need protection from Gulf oil reserves to ensure a modicum of domestic oil price stability.

So it all boils down to storage cost and infrastructure. With the world coming to a standstill, demand for fuel as come to a screeching halt. Where to store the oil extracted from offshore and onshore wells? The negative price reflects this — producers would be ready pay the storage cost so that someone takes away the oil that otherwise would overflow and flood land or spill into the ocean.

Against this backdrop, the US’ Strategic Petroleum Reserve is once again gaining traction. Crude oil when available cheap is stored in cavernous mountains, to be used when there is a shortage. The US Energy Information Administration last week reported a record 19.3 million-barrel crude stock-build. There are currently 21 million barrels for storage available at the Cushing hub in Oklahoma. This capacity would probably be used up too, in the days to come.

Indian oil refineries are too constrained to claim force majeure and ward off shipments in the wake of coronavirus-induced economic slowdown. In addition, the Indian government is trying to emulate the US by stocking up cheap oil when it is available. India has three strategic petroleum reserves at Vizag (1.3 million tonnes), Mangaluru (1.5 million tonnes) and Padur (2.5 million tonnes), which were readied between 2015 and 2018. At full capacity of 5.33 million tonnes, these can provide fuel security for nine days for the country.

About 45 per cent of the total capacity has been empty, and will now hopefully be filled by State refiners. Admittedly, the Indian strategic storage capacity is limited as against the US. Indian refiners must buy cheap crude and store. We need to build a more cavernous storage capacity, though that is not without risk.

Laypeople were bemused when they heard about the Japanese central bank paying negative interest to its banks and financial institutions. If storage cost explains the negative oil price conundrum, the need to revive the economy explains the negative interest. In fact, the RBI’s repeated and staggered lowering of reverse repo rate is in line with the Japanese initiative — banks should be discouraged from seeking the comfort and safety of parking their funds with the RBI. Who knows, in the months to come, the reverse repo rate might be in the negative territory, if our banks remain stubborn and do not lend to industries!

The writer is a Chennai-based chartered accountant

Published on April 21, 2020
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