Negative Oil Prices | Explained by Dailyvani

Hello friends,

The price of crude oil has gone into the negatives across the world.

At the time of 22 April 2020, the price of WTI crude oil is minus 16 dollars per barrel
minus 16 dollars!

It has never before happened in history that oil prices have dropped below zero.

A lot of mockeries are being made out of this. A lot of memes are being made on the internet.

It might come across your mind that perhaps if you go to a petrol pump to get your car tank filled,
the petrol pump people are going to pay you to get your tank filled up.

This does not mean that, friends.

What exactly is the meaning of this?
Why has the oil price dropped into the negatives and what will its consequences be?
We are going to talk about all of this in today's article.

Come, let us see

Supply Vs Demand

First of all, I'd like to remind you of a basic economics lesson.

Have a look,

The price of anything in a free market depends on demand and supply.

  If the demand of something is more while the supply is less, then its price will rise. The same is with oil. If the demand of oil is less and the supply is more, then its price will fall.

The matter of fact is that the demand for oil worldwide has fallen so drastically in the past month
that no one had expected it.

The flights have been canceled due to the lockdown. So the demand for jet fuel dipped.

The people have not been stepping out of their homes, so the demand for oil in car tanks also fell.

The factories are all lying shut, so the demand for the requirement of crude oil there too, has fallen.

So the demand for crude oil has fallen in so many places and as we already know, if the demand of something falls, then its price too, will follow suit.

But if the supply is reduced too, then the price can be kept stable.

Now, as all the oil-producing countries are at loggerheads with one another Russia, Saudi Arabia, USA.

Who can make their competition the best and this is why they were not agreeing to cut down on their supply.

But the demand fell so drastically that all the oil-producing countries have finally realized that they were incurring losses themselves if they refrain from taking action and cutting down supply.

So, finally, on 13th April, all these oil-producing countries, I wouldn't say all, but almost all of the oil-producing countries finally worked out an agreement, a historic agreement because before today- for Saudi Arabia, Russia, and the USA to agree on the same thing together had never happened before. I mean, this rarely happens.

But on 13th April, Drumpf worked out a deal with Saudi Arabia and the OPEC + countries.
OPEC+ includes both Saudi Arabia and Russia, that they would reduce their supply by 9.7 million barrels per day, and reducing supplies would keep prices stable and they all could make a respectable amount of profit.

Despite this, the oil price crashed further below on 20th April and it ran into the negatives
At its worst, it reached minus 40 dollars per barrel.

Let us talked about why this happened

What are Oil Benchmarks?

If you've been attentive, I had said at the beginning of this article that the WTI benchmark of oil is in the negatives.

So what is this WTI benchmark? We will have to understand this first.

What regions of the world is crude oil found in? Which quality of crude oil is available there?

It can so happen that better quality crude oil is found in some regions and some regions have inferior quality crude oil. Some regions have oil with a higher sulfur content and some regions have oil with lower sulfur content.

Some regions have oil reserves in the land and some have them in the oceans.

The oil from the land reserves need pipelines to be transported and hence they are difficult to be transported.

Ship tankers can be made use of easily to transport oil from the ocean reserves.

So basically what I'm trying to say is that the crude oil extracted from different regions has different qualities and if you are an oil buyer and want to purchase oil, then you will have to keep in mind the things like the region that you are buying oil from, what quality oil are you buying and how cheap it will be to transport that oil.

But how are you going to decide what value should be assigned to which crude oil?
How much money should be given for this level of quality of crude oil?
How much money should be given for that level of quality of crude oil?

Benchmarks exist for this purpose.

There are different benchmarks for crude oil coming in from different parts of the world.

Benchmarks are basically a reference line to compare the values of the different crude oils.

Although there are a lot of different benchmarks for oil in the world there are three main benchmarks where the oil coming from all the different regions of the world is referenced against.

WTI vs Brent Crude

The first and most popular benchmark is Brent Crude. This is the oil that is extracted from the North Sea near the UK and Ireland. This oil has a high sulfur content and this oil is good for (the production of) diesel. It is extracted from the sea. Two-thirds of all crude contracts in the world use the Brent Crude for reference.

Now, what are crude contracts? I will talk about this later in the article.

The second benchmark is West Texas Intermediate. This oil is extracted from the wells in the USA. This oil is extracted from land reserves and is transported through oil pipelines. There is a state in the USA- Oklahoma. This oil gets transported there and this is the main delivery point to obtain this oil.

There is one difference that you can already see here.

The Brent Crude oil is extracted from and transported through the sea. This one is extracted from the land. Obviously, it is more difficult to transport.

And the third benchmark is Dubai and Oman. The oil extracted from the Arab countries is viewed in reference to this.

The situation today, as you might have noticed, the WTI price has fallen into the negatives
But the price of Brent Crude is still in the positive +20 dollars per barrel.

Why so?

One reason behind this is that Brent Crude is extracted from the ocean. It is quite easy to store and transport in ship oil tankers.

Why Negative Prices Happened?

But in the case of WTI, it( the oil) is extracted from the land. It is transported in pipelines and brought to Oklahoma, which is the sole delivery point, as compared to Brent Crude, which has multiple delivery points.

All the ships can come and take their oil from their facility. Here, (in the case of WTI) the entire oil is brought and collected in Oklahoma.

In fact, there is a town by the name Cushing. This is where all the oil is stored. The majority of the oil storage facilities of the USA are housed here.

So there is a lack of storage in this case. So this is why there is such an acute shortage of storage for the oil producers there that they're saying that they would pay to take away the oil because they don't have enough space to store it. They already have produced so much. This is a very simplistic explanation.

There are more complexities in this. I'll tell you.

What are Future Contacts?

Let us now talk about what crude contracts are

The trading of crude oil today, that is, buying and selling of crude oil are done through future contracts.

One way would be that the seller sells directly to the buyer and the buyer pays him
How much does he pay?

The buyer pays the seller according to the value of crude oil price at that specific point of time in the market and the job is done.

But nobody does this.

Nobody does this because the price of crude oil fluctuates so much in the market. It becomes risky for both the buyer and seller. If they do not know what price would they sell the oil at.

Assume they produce a specific number of barrels of oil but they do not know for how much are the rest of the barrels going to be sold in the future. If the price of oil falls very low in the next month, then they would have to incur huge losses.

This is why future contracts are made and futures contracts are basically like pre-ordering.

The buyer and seller make a consensual contract to trade a specific amount of oil at a specific point of time. That means, there's a date in the future when the oil would be delivered, at a specific price. The price is already pre-decided. The date of delivery is also pre-decided. This tells the producer how much oil he has to produce and there's a guarantee that he would get the pre-decided price. He would not be in the complete loss.

This is what is called future contracts.

Now, there's a very interesting thing here- the future contracts between the oil sellers and the oil buyers.

Such future contracts can be bought by people like you and me

Now you'd ask what you can do by buying such future contracts. You have no use for crude oil
Actually, we will not buy these future contracts to get crude oil but to earn money.

Basically, somewhat like middlemen.

We take the future contracts from the oil sellers and wait for the oil buyers until the price of oil goes up and then sell it to the oil buyers and we earned money by being the middlemen. This is called the futures trading.

Several investors do this to make money.

So, viewing from the seller's perspective, I took out a future contract and left it open in the market.

Now, if the market feels like the oil is getting more valuable, then my future contract will be bought at a higher price and if it feels that the oil price is falling, then my future contract will be bought at a lower price.

And who is the market here?

The investors, traders, and common people who speculate what the price of oil will be. This is called a free market.

This can be talked about and a philosophical discussion can be done on it.

But basically, the price of my future contract will then get reflected in the benchmark. The benchmarks that I previously told you about.

They basically denote the price of the futures contracts and they keep fluctuating regarding it
Now, the price of the oil has crashed into the negatives.

Talking specifically, the future contracts under WTI, in the month of May. It has become negative for that. It is still positive for the month of June.

Obviously, the WTI benchmarks state an average cost of all the future contracts. The future contracts have dipped low only for the month of May. Because the investors and traders are viewing the situation today.

The situation today is that there isn't enough space to store (oil) in Oklahoma. This is why they do not want to buy the futures contracts for the month of May. This is why they are selling for the month of May and they feel that the situation will revert to normal in June and the demand would rise slightly.
And this is why the contracts of June are again in the positives.

Another thing that you can conclude from this is that the oil price will not remain negative for long.
This is being speculated.

But some economists and experts believe that the explanation that I gave you here as to why the oil prices have become negative.

This is not a satisfactory explanation for this.

Some experts believe that they are more reasons behind this.

There have been some wrongs due to which they have become negative.

Effects Of Negative Prices

Now there have been enough explanations. Let's talk about the consequences now.

What effect will the negative oil prices have on you and the rest of the world?

Let us talk about you first,

Honestly speaking, there wouldn't be a lot of effect on the end consumer and a common man. However, observing ideally, crude oil is used to manufacture a lot of end-consumer products.
Petrol and diesel too, are dependent upon crude oil.

So if the crude oil is running in the negatives, then all these things should become cheaper ideally.

But this would not happen in reality.

There is a very high probability that the government will not pass on any benefits to the consumers
The reason behind this is that there is a recession worldwide. If you have didn't watch the Globa Recession 2020 article than read it by clicking here.

The government might pass on a paltry benefit.

But in my opinion, no such benefit will be passed on to a large extent. The government would try and offset the economic losses that are affecting the entire country with the extra profit that the government makes here,

And the same thing stands for companies as well. The big companies that manufacture consumer products will manufacture at cheaper rates due to the cheap crude oil.

But they will not pass on their benefits to the end consumer because of the same reason
They too have had to bear losses due to the coronavirus lockdown.

But in a broader sense, all the oil-importing countries like Germany, Japan, and even India all have a huge advantage.

The governments here can try to utilize and take advantage of the ongoing low prices of crude oil. If these countries try to improve their storage facilities they could buy oil for cheaper rates and store it for later use. So this too would be a huge advantage here.

This opportunity can be utilized in a good way.

But the rest of the countries that produce oil are in a loss especially, in the USA, where a lot of small businesses will shut down because they are incurring huge losses due to such negative prices of oil.

The same situation is in Canada too.

From the perspective of the environment, this is both good news and bad news.

The good news in the sense that the people who run the oil companies that are shutting down might now think about shifting to renewable energy and investing in clean energy They would make more profits there and it is better than incurring losses here.

But it is bad news for the environment because oil would be cheaper and so from the perspective of a consumer, petrol, and diesel would become cheaper petrol and diesel cars would become cheaper.

So if crude oil becomes so cheap then no one would want to invest in renewable energy There would be no economic incentive for electric cars and renewable energy.

I hope you would have found this article to be informative.

I don't think I have ever tried to simplify and summarize such complex information in an article before.
If you failed to understand something, you can  re-read it and even then if you do not understand it, then research on your own the key terms that I have used in the article
You can search for them and conduct your own research

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We will meet again in the next article.
Thank you