A simple explanation on how the price of oil fell

By Larissa Fernand |  21-04-20 | 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

The jaw-dropping collapse in a key segment of U.S. oil trading has certainly made history.

What happened was that the price on the futures contract for WTI, that is due to expire Tuesday, fell into negative territory.

The pandemic has brought economies to a standstill. American energy companies have run out of storage facilities. And if there’s no place to put the oil, no one wants a crude contract that is about to come due. So if nobody who can store it will buy it from you, you have to pay someone to get rid of it.

Understanding how it happened

The monthly oil contract was about to expire. So firms who trade contracts offload them to physical buyers to take physical delivery.

If an energy trader had a May contract at expiration, he has to take physical deliver of a 1,000 barrels of oil.

The energy trader wanted someone to pay him to take his oil contract so he does not have to take physical delivery.

But there were no takers, and the price kept falling. Storage and refiners were not buying. The physical energy trader countered with, you pay me for every barrel I take off your hands.

Consumption of oil has dropped significantly. Production has  not. Hence the imbalance.

Morningstar’s senior equity analyst Mark Taylor shares his views

The fact that prices have gone negative is more about virtual markets than the physical. If you are a trader and you are locked into a future for physical delivery and have no physical storage capacity—and don’t want your backyard swimming pool full of oil—then you have to pay someone to take it off your hands.

This will exist for a short period but it's not going to go on indefinitely. Energy is at the foundation of all economies. You can't survive without reliable and consistent energy supply.

The decision by Saudi Arabia and Russia to finally agree to reduce their oil production is very important because you've got this situation with an excess of supply into a demand scenario that's been completely routed out by coronavirus causing lockdowns, people to stay at home, so they are not driving as much. You're not travelling. So, airlines grounded. That's about a sixth of oils consumption there gone away.

On top of that, the Saudis and Russians breakdown in agreement to curtail supply. So, excess of supply into the market.

In the short term, it's very important that they've come to this agreement. I don't expect that it will result in some magical rebound in oil price back to where it was because the coronavirus effect is going to persist for some time yet. But eventually, you should see a recovery in oil price to some of semblance of a sensible level which we think is about $60 a barrel Brent.

Currently it is at around $30 a barrels.

Global production is not even being incentivized to invest to drill and sustain and increase production, particularly U.S. shale producers for whom a $40 a barrel price is where they start to breakeven on average.

WTI, Brent, ORB, Oman Crude

The two most popular benchmarks for international oil prices are West Texas Intermediate, or WTI, which is a U.S. measure, and Brent crude, which covers oil located outside of the U.S.

WTI trades on the New York Mercantile Exchange, or NYMEX, and Brent trades on ICE, the InterContinental Exchange, a leading network of regulated exchanges and clearing houses for financial and commodity markets.

Brent crude has overtaken WTI as the global benchmark and is generally seen as a more accurate reflection of the true price. Incidentally, the term 'Brent' comes from the formation layers of the oil field - Broom, Rannoch, Etieve, Ness and Tarbat.

Another common benchmark for crude oil prices is the OPEC Reference Basket, or ORB. This price consists of a weighted average of a mix of crude oils found in the OPEC region. The Organization of the Petroleum Exporting Countries, or OPEC, was founded in Iraq in 1960. The member countries currently are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE and Venezuela. OPEC produces 30 million barrels per day (bpd).

Saudi Arabia is considered to be the ‘swing’ oil producer. A swing producer is a country that changes its crude oil output to meet fluctuations in market demand. Saudi Arabia is seen as the world’s major swing producer, in that it will cut or expand production based on total global output to maintain a certain oil price. At the height of the Libyan crisis, for example, Saudi Arabia increased production to offset the fall in supply from Libya.

Besides Brent, WTI and ORB, another benchmark to note is Oman Crude which trades on Dubai Mercantile Exchange, or DME.

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Ateet Wagh
Apr 21 2020 05:48 PM
 Excellent information... Thanks.
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