Crude oil is one of the most traded commodities globally. The reason for huge trade volumes is the dual-use nature of the commodity. Crude oil is primarily used as a source of energy, but it is also used as an investment product for portfolio diversification by some investors. An important aspect of the crude oil trade is that it is not a uniform commodity. Over 160 types of crude oil are traded in the global market, but not all are tracked with equal zeal. Brent crude and US West Texas Intermediate (US WTI) are two of the most tracked crude oil types and are considered as the benchmark in crude oil trade.
On April 21, the US WTI created global headlines when the value of its May future contracts plunged below zero. It was the first time in recorded history that crude oil prices dropped into negative territory. It essentially meant that producers were willing to pay buyers to take crude oil off their hands. The unprecedented event leads us to think of the reason for the crude oil price drop. Multiple factors were responsible for the crude oil price drop. Some were immediate while others have to be seen in the larger context.
The ground for the historic oil price plunge had been set long before the fateful day. Oil producers were struggling with overproduction long before the Covid-19 crisis hit and wiped off the demand for the liquid commodity. The emergence of shale oil in the US changed the dynamics of the crude oil industry around half a decade ago. To protect their market share from shale oil, major producers like Saudi Arabia and Russia flooded the market with cheap oil. The cost of crude oil production for the gulf nation and Russia is relatively lower than shale oil producers. Nevertheless, all the producers pressed ahead and crude oil prices never touched the $100-mark after 2014.
The Covid-19 crisis made a bad situation worse. Governments across the world put varying degrees of restrictions on travel and movement which led to a crash in demand for crude oil. Large producers like Saudi Arabia and Russia accelerated oil production and flooded the market with cheap crude oil to protect their market share. Significantly low demand coupled with oversupply led to a crude oil price plunge. With large quantities of cheap oil sloshing around the market, storage capacity started filling rapidly. Russia and Saudi Arabia announced a production cut in early April, but experts believe no country can reduce enough production to balance supply with demand.
The immediate trigger
Along with the physical oil bought for actual consumption, many investors buy crude oil futures as an investment product. The price of crude oil futures is connected to the actual consumption of the commodity. The futures contracts can only be sold if there is someone at the other end to buy and consume the oil. The pandemic distorted the market conditions. The rapid spread of the novel coronavirus resulted in lockdown for 90% of the world. With no aeroplanes flying or vehicles plying on the road, the demand for crude oil vanished. Traders who had bought May futures of US WTI were suddenly staring at the prospect of finding no buyers for the contracts. No one would buy the contract if there is a lack of storage as well as demand.
In normal circumstances, traders would have easily rolled over the contracts, but certain changes brought by US Commodities Funds that manages the largest oil ETF made rollover difficult. Traders who had May futures of US WTI crude on April 21 were trapped as the contracts were set to expire on April 22. This led to panic selling by traders who dumped May WTI contracts in bulk. The dumping resulted in the value of May contracts of US WTI falling to minus $37.63 a barrel.
Crude oil prices dropped across the world, but the negative value was witnessed only in US crude oil. The reason for the crude oil price drop in the US was a scarcity of storage space, immediate expiry and lack of demand for the commodity. Crude oil prices are expected to remain suppressed with grim predictions for the global economy, but negative prices will remain a rarity.