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First Time in History -- Crude Oil Price Turns Negative

On Monday, April 20th 2020, the US crude oil futures collapsed below $0, ending at a negative $37.63 or negative Rs 2850 per barrel. This effectively means the producers are willing to pay buyers to hold oil.

Before we discuss further, it is important to understand the concept of futures and how they work: Futures are financial instruments that allow you “fix” the future price of a commodity, in this case oil. These instruments come with a specific trigger date, called “expiry”.

So, for example, if a crude oil future expiring on June 21st 2020 is trading at say $20 per barrel in the commodity market, you can buy it and effectively lock in the price of oil. At expiry (which is June 21st), you’d be entitled to get crude oil at $20 per barrel irrespective of the going rate of oil – higher or lower than $20 – on June 21st. This way, you are effectively “protected” from the volatility in oil prices.

The caveat? At the end of the expiry period of futures, you must take physical delivery of these oil barrels. If you do not wish to take delivery because, say, you do not have space to store these barrels, then the only option left for you is to sell the futures you had bought earlier to someone else who is willing to buy them from you. But this must be done before expiry. If there are no buyers available, you have to take delivery.

Taking physical delivery of oil barrels is not much of a problem for institutional investors who have access to storage facilities. They may sell these barrels a few months down the line at a profit – net of storage costs – when the world economy, and therefore the oil price, recovers.

But traders buy commodity futures on a short-term horizon – as short as a week or even a day. They do not intend to take deliveries, but instead sell the futures position to another buyer before expiry. Since crude oil is one of the most traded commodities in the world, finding a buyer, whom the futures position can be smoothly transferred, has not been much of a problem.

But the coronavirus outbreak has changed this.

Most of the storage facilities across the key hubs of the US, one of which is a small oil town called Cushing in the state of Oklahoma, are booked.

As per some reports, several large offshore oil carriers called VLCC, which can carry upto 2 million barrels, now cost as much as $100,000 to $1,50,000 per day – yes, you read that right. Earlier, they cost $25000 per day.

Why has the US run out of storage facilities? It’s because many investors had booked them earlier, betting on a rise in oil prices once the coronavirus pandemic settles down and the world economy recovers so they can sell the oil barrels at a profit – net of storage costs obviously.

This is why the June oil futures, or July, or August still trade at above $15 per barrel.

So, to sum up, the US lacks storage facilities and offshore oil pipelines and tankers are obscenely expensive for storing oil, causing long-term buyers of oil barrels to stay away from participating in the futures market. Meanwhile, the supply of oil continues to stay high, despite the OPEC+ (OPEC plus Russia) players having agreed to cut the daily production by 9.7 million barrels starting May.

As for India, normally every $10 drop benefits the domestic GDP by 0.5 per cent. It also lowers inflation by about 0.3%. But since both the demand and supply of crude oil are inelastic in the short term, the impact of this reduction is unlikely to trickle down to the ground level anytime soon. For those of you who may be unaware, elasticity is just the change in the quantity of oil supplied or demanded with every $1 change in its price. Also expect excise hikes on fuel, especially given the expected massive fall in government's tax revenues owing to the virus-related lockdown.

In terms of industries, in the long run this should benefit autos, paints, oil retailers and marketers, rubber & rubber chemicals, aviation, cement, and a host of manufacturers that use crude or crude derivatives as inputs or for transportation. Obviously, in the near term the industrial outlook would continue to stay negative until the overall consumption recovers.

Disclosure: This is not an investment recommendation or a stock advice.