How Oil Prices Went Subzero: Explaining the COVID-19 Oil Crash

We are all seeing the news flash talking about oil prices going negative. So here is a very brief simplified explanation for what's happening:

• Most of the oil is traded via Futures Contracts. There is a Spot Price as well, which is taken into account while arriving at the "theoretical futures price"
• There are two main Futures Contracts (remember this is simplified) - The WTI and the Brent
• WTI refers to the Oil from North America, while Brent refers to oil from Middle-east, Europe and Russia
• There are a million variants, but we will omit those for the moment since they complicate the discussion without really adding any clarity
• The "Oil Price" that's gone negative is the settlement prices for the May 2020 Delivery Contract (ONLY THAT ONE)
• Some more complexity - There are two forms of settlements for Crude Oil Futures Contracts (and for most commodities), viz Net Settlement and Physical Delivery
• The net settlement allows the buyers of the contracts to settle the financial difference between the buying price and the settlement price
• If a buyer of a Futures Contract doesn't opt for net settlement on or before the "Notice Date", which passed last week for the May 2020 Delivery, then they are assumed to be taking physical delivery of the underlying quantity of Crude Oil
• And that's the "technical problem" that's pushing the settlement price of May 2020 Delivery Contracts to become negative. There is a buyer, or a series of buyers, who are stuck with physical delivery option that they can't actually use, ie they can't take physical delivery of the underlying crude oil because they don't have the storage capacity to store this
• The negative price indicates that they are getting some buyer, probably a refiner, or a storage facility or a driller, to take the delivery off their hands by PAYING them to buy the oil that's ready for May delivery
• It's never happened before in the history of Crude Oil Futures trading. It's a very unique situation
• However, the June delivery WTI futures are still trading in positive territory at $20+/ BBL (as on 23/04/2020). And the Brent Futures for June 2020 delivery are trading at $25+/ BBL (as on 23/04/2020)
• Will this have implications: surely so. It means that the US Crude Oil producers are now facing a glut and if they don't stop drilling, they will have to give the oil away free, and/or pay people to buy that oil.
• This oil can't be dumped or disposed off, since that will cause an environmental disaster and result in billions of dollars of penalty (Exxon Valdez, Deepwater Horizon, etc.).

By Aditya Sureka

(Mail Id: aditya.sureka007@gmail.com)

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[Disclaimer:-This article is being furnished for informational purposes only. We make every effort to use reliable & comprehensive information, but we do not represent that the contents of the article are accurate or complete.]