A dispute between commodity exchange, Multi Commodity Exchange (MCX), and brokerages came to light after the US benchmark crude oil prices turned negative for the first time in history earlier this month. Owing to the unforeseen losses caused due to the unprecedented fall in oil prices, MCX, according to news reports may set the bottom price for 100 barrels for crude oil in India at Re 1.
According to news reports, MCX is in talks with the market regulator SEBI to announce a norm to set ₹1 as bottom price for 100 barrels of crude oil in india. This comes after the negative prices led the MCX to settle crude oil contracts at minus Rs 2,884 a barrel that caused a huge uproar among the brokerages.
In response to this move by the MCX, a group of brokerages moved to the High Court claiming that there was no provision in India to trade commodities by assigning a negative value to it and that the move by MCX was arbitrary and illogical.
Why did the price turn negative?
The lack of demand for oil amid the nation wide lockdowns, due to coronavirus spread, had sent the US benchmark oil contract, known as West Texas Intermediate (WTI) as low as minus $40 a barrel earlier in the month.
The negative price essentially meant that crude oil producers were willing to pay the buyers to take away oil from them. The negative prices were a result of the storage of storage capacity at delivery point in Cushing, Oklahoma.
- Over supplied oil market
The oil prices turned negative not only because of a lack of demand for oil amid the lockdown announced by several nations but also owing to the price war between major oil producing nations, Saudi Arabia and Russia. A deal between the two nations to limit oil production collapsed which caused a massive oil glut.
Why were traders not able to cut positions ?
The negative prices left the traders in India in a precarious position. Crude oil contracts on MCX reflect the prices on New York Mercantile Exchange. As the trading hours in India were curtailed to 5 p.m., due to the lockdown, traders were not able to cut positions before the prices slumped into negative territory on the NYME.
Thereafter, several brokerage houses jointly had to move to Bombay high court against MCX, as it settled crude oil contracts at minus Rs 2,884 a barrel. Brokers incurred a loss of over 400 crores due to negative settlement price of crude oil. It must be added that MCX had initially announced a provisional settlement price of Rs 1 for its contract that ended on 20 April.
Crude oil settlement issue
The brokerages in their petition said that no commodity exchange in India has any provision to trade commodities by assigning a negative value to it. They further termed it arbitrary and illogical.
“Crude futures contracts are settled in cash on the exchange and there is no delivery-based mechanism for these contracts in India and, therefore, these contracts can be traded at base price of Re1 to say the least in case of an unprecedented eventuality.
Thus, assigning a negative value is arbitrary and illogical and demonstrates an utter disregard of basic principles and fundamentals of the settlement system in India,” the plea said according to Mint.
What is the trading mechanism?
Futures are derivative contracts that allow a trader to sell or buy a commodity or a stock
at a future date. On the date of the expiry, the buyer either delivers the asset or pays cash to settle the contract value. The profit or loss on a trade is the difference between the buy price and settlement price on the trade.
Negative MCX crude contract settlement
MCX may have taken cue from the April 8, 2020 advisory issued by CME Clearing, the clearing arm of NYMEX. It suggested that plans were underway to support the possibility of negative prices.
On April 15, 2020, CME Clearing announced that its trading and clearing systems had been enabled to trade in zero or negative prices and allowed trading firms to test such negative futures in the new systems released by the clearing corporation.
Conclusion: The dispute between MCX and the brokerages has highlighted the lack of risk management with regard to crude oil trading. However, the recent move by the MCX seems to be in the right direction. By setting ₹1 as bottom price for 100 barrels of crude oil in india MCX
will bar the traders to put negative price quotes. The negative prices and the historic oil price collapse also reveals the magnitude of risk posed by the current Coronavirus pandemic. The world’s most important commodity, for which wars have been waged in the past, is fast losing its value.