When black gold turns red


Oil zero

WE NEVER thought we would witness the day when a seller pays a buyer to purchase oil or that one day where even a glass of water is perhaps more expensive than a barrel of oil.

Could we ever imagine that oil turned into a negative commodity that nobody wanted, well at least for that one day? With all the records that we have seen in the Covid-19 pandemic in the financial markets, nothing will ever beat the record negative price of US$37.63 per barrel on the benchmark US West Texas Intermediate (WTI).

Oil, which is also known as the black gold due to its value to humankind, has turned red, well, at least for that one day.

WTI is a benchmark oil adopted in the United States while Brent crude is the standard for outside the US.

Interestingly, while both are oil benchmarks, they do not necessarily trade at the same price as there are occasions when WTI traded at a premium to Brent and in other times, the latter trades at a premium.

However, as both are benchmarked against the same underlying asset, the price movements tend to correlate with each other rather closely.

As seen in the chart, Brent has always been trading at a positive spread over WTI and only briefly did the latter trade at a premium to Brent over the past 10 years or so. On average, Brent has traded at a premium of about US$7.50 per barrel against WTI over the past 10 years.

The positive spread enjoyed by Brent is due to its more “international” stature compared to WTI, which is more American-centric. So although the spread widened to as much as US$63.20 per barrel between the two benchmarks on Monday, that spread normalised once the WTI May contract expired.

Among the reasons cited for the WTI trading at negative territory for the one day is because it is actually a physically settled contract and not cash-settled contract like Brent.



For a contract that is physically settled, if you are a buyer of the contract at the time of expiry of the contract, you would need to take delivery of the 1,000 barrels of oil stored for you.

Of course if you are a seller, you would need to deliver the 1,000 barrels of oil to the major trading hub and storage facility, located at Cushing, Oklahoma. As there are no buyers as storage capacity was fully leased to oil majors and traders, it added pressure on the WTI price. Hence, crude oil went south.

Another reason for the negative WTI price was due to the contract expiry. Here, non-oil participants are also present and among them are the speculators, the hedge funds or even oil-based exchange-traded funds (ETFs).

The most famous ETF is the United States Oil Fund (USO), which basically tries to mirror the performance of the underlying asset.

The USO, with more than US$4bil in net assets, accounts for as much as 25% of market share in terms of volume and positions in the futures market. The fund inflows into USO quadrupled since early March as weakness in oil prices saw entry of more investors/speculators taking position on the ETF based on the view that oil prices will recover.

The built-up in funds under management in USO was driven by the fall in oil prices after the Saudi-Russia stand-off in production output and a price war in early March.

For the May contract that expired last Tuesday, traders and speculators who have no intention to take physical delivery of oil and would normally rollover their open positions to the next contract month.

Hence, if they were in a long position, the rollover position occurs when the market participants close out their long position by selling the current contract month and buying into the next contract month, which is the June month.

This alone is costly as the spot month May was trading at a significant discount to the June contract month, which results in a huge rollover cost.

Assuming a market participant have no choice but to sell the May contract even at US$1 and buying the June contract at US$21, that negative roll yield alone is US$20 per contract and that is equivalent to US$20,000 loss as one oil futures contract is 1,000 barrels.

Oil, being a commodity is driven by two simple factors – demand and supply. Of course there are many factors that drive the demand and supply for oil itself and in today’s environment where more than half the world population is in some form of lockdown or controlled movement, demand just evaporated.

It is estimated that demand for oil has dropped by as much as 30 million barrels per day from its daily normalised demand of about 100 million barrels per day, while supply remains in abundance.

The recent cut by Opec+ of 9.7 million barrels per day only helped market sentiment for a day or two as the reality of the market takes precedence. In fact, there is just too much oil, not only oil stored at Cushing but even storage capacity elsewhere, including some 160 million barrels of oil at sea in some 60 super-tankers.

With the global economy stuck in a rut due to Covid-19, demand for oil is not expected to pick up anytime soon.

Until and unless we reach some sort of clearing of oil held in storage capacity, we are unlikely to see oil coming back to last year’s average price of US$64 per barrel or even year-to-date average price of US$47 per barrel.

It doesn’t matter if the futures market is exhibiting rising prices in forward month. The dynamics of demand and supply could easily crush prices if the former remains weak while the latter remains in abundance.

With the volatility seen in oil prices, investors are wondering if we are going to see more volatility in other commodities or financial assets and another trillion dollar question would be whether central banks will step in to calm markets yet again?

As for oil, even if economies around the world begin to open up post Covid-19, the return to the new normal is going to take time. Hence, demand for oil is unlikely to revert to pre-Covid-19 anytime soon and unless we see some sort of equilibrium in supply, oil prices will remain where they are and that is a reality.

The views expressed here are the writer’s own.

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