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Crude Oil price turned negative yesterday but it won’t affect Indian prices, six questions about the price crash explained

The price in fuel in India is based on the average of the prices of Brent, Dubai and Oman crude prices, and WTI price which crashed is not a factor in it

As the world economy continues downfall due to the Coronavirus pandemic, the WTI crude price went negative for the first time history on Monday. The May contract prices for WTI crude oil crashed rapidly, going from few dollars to negative in a matter of minutes, after reaching a low of -$40 per barrel, the price settled at -$37.63 per barrel at NYMEX (New York Mercantile Exchange) on April 20. The price went down by more than 300% in a single day.

Source: CNBC

Indian Twitter was keenly following this rapid development last night, as the financial media houses live-tweeted the constantly decreasing price of crude minute by minute. Many assumed that crude prices have crashed globally, and demanded that the benefit of the crash should be reflected in the retail price on fuel in India. Congress MP Shashi Tharoor, who has made it a habit of making comments and demands without knowing the facts, also demanded that Govt of India should “finally relent and pass some of this windfall onto the beleaguered Indian Consumer”.

‘Crude price has turned negative’ is a misleading news, because despite the crash in markets yesterday, we are not going to see a steep decrease in fuel prices, even though prices will remain low.

This is because, what crashed was only the May future prices for WTI, will not have much elsewhere in the world. Let us see what those words in this sentence means.

What is WTI

West Texas Intermediate, the WTI is the benchmark crude oil price in the USA. It is a grade of crude oil which is the underlying commodity of oil future contracts in the New York Mercantile Exchange. The WTI is mainly produced in the USA, primarily from the Permian Basin in Texas and other nearby states. Other major grades of crude are Brent crude, Dubai crude, Oman crude etc. Brent crude is the major crude traded globally, and India also buys mainly Brent. Therefore, a fall in WTI price does not have much implication for India.

What is future contract

Future contract is a kind of transaction in commodities and financial instruments like equities. It is essentially a contract between two parties for a transaction in future but at a price fixed at present. For example, lets say party A offers to buy something at ₹1,000 per unit two months later, regardless of what will be price of that commodity at that time, and party B agrees to sell it at that price at that time. So, both parties A and B will enter into a contract to buy and sale that commodity at ₹1,000 per unit two months later, this is called a future contract. If the price of that commodity is more than ₹1,000 2 months later, party A makes profit because he is getting that item at ₹1,000, while if the price becomes lower than ₹1,000 he makes a loss. The situation is exactly opposite for the seller, who makes profit if the price goes down but suffers loss if it becomes higher than the contract price. Just like stock exchanges, there are exchanges where future contracts are traded.

Oil is one of the major commodities which is traded in the future market. There are two kinds of people who deal in Future Contracts. Some people are in the market only to speculate on the contracts, they buy and sell them before the maturity, treating it as any other financial instrument. While others buy and sale because they need the oil to use or have actual oil to sell. Oil refineries opt to buy in future at a predetermined price, to maintain stability in supply of crude, and oil producers also have assured buyers for future.

What is May Contract

Future Contracts have a maturity date, the date on which the actual transaction will happen. Oil futures are traded on a monthly basis, there are different futures for each month. Before the maturity date, the futures can be traded, and on the maturity date, whoever is having buy option will have to take delivery of the crude from the seller. Yesterday was the last of trading on the May future, and today delivery of those transactions will happen. While the May Future crashed and turned negative, the June contract was trading at a much better price of above $20 per barrel, and the July contract price was above $26 per barrel.

The price of June Contract Brent Crude, the main crude traded internationally, was above $25 per barrel. Therefore, it was not an across the board crash in price of crude, but only the price of May Contracts crashed just before its maturity.

Why May Contracts crashed

The rule in future trading in WTI crude is that after the contracts mature, the buyer will have to take delivery of the crude from the seller. And this handover takes place in one place, a town named Cushing in Oklahoma. Cushing is a major trading hub for crude oil and price settlement point for WTI crude. This is where the crude is delivered by the seller to the buyer.

Pipeline Crossroads of the World monument in Cushing

But as the world has come to a standstill due to the Coronavirus, there is no demand for oil. This means oil is sitting in storage facilities, and there is no more capacity to keep any new oil that is coming. Both mega tankers floating in oceans and massive storage facilities on the ground, including the storage at Cushing.

As there is no place to store the commodity, it became worthless. Moreover, even if there are place to keep it, there are no buyers, so it will be sitting in storage tanks, which will mean incurring cost with no certainty when the market will improve. That’s why the those who were having the future contracts started selling them at the exchange before the maturity date to avoid taking delivery. Exchange prices are a factor of demand and supply, if there is more demand then available supply, the price rises, and if there is more supply but few takers, the price comes down. As everyone was selling and nobody was buying the May contracts, price crashed, and ultimately turned negative.

The negative price means that investors holding May contracts had to pay people to take away the oil from their hands, as they didn’t want to incur storage costs.

Why there is so much oversupply of oil

The global economy started to take a hit due to Coronavirus from February itself, as countries had started restrictions on international travel. But the crude production continued by producer countries due to conflict between major producers like Saudi Arabia and Russia, creating a huge stockpile with no takers. Earlier this month, the OPEC+, the group of oil producing countries which includes the OPEC counties, USA, Russia and other countries, agreed to cut production of oil to maintain stability in price. But the group agreed to cut production by 9.7 million barrel per day, which is around one third of current global oversupply. Plus, the cut starts from May 1, which meant producers kept producing oil in April and flooded the market. Oil storage tanks and pipelines will be full even before the production cut begins, which has resulted in the sharp drop in prices.

Why Indian oil prices will not come down due to the negative price

As already explained earlier, India is not a major trader in WTI crude. Although Indian oil buyers are active participants in crude futures, most of them are in Brent, Dubai and Oman. Even in normal times, only a small amount of crude is imported from USA. This is because, even if WTI price is hovering at lower level than Brent for considerable amount of time, the cost of transporting it from USA to India offsets that benefit.

It also not possible to take benefit of the negative price in the USA, because the delivery of that oil have to be taken in Cushing in Oklahoma, and will have to transport from the middle of the USA to coast, and then ship it all the way to India. Given that even Brent price is very low at present, it does not make any sense to go to the USA to buy oil as even if the purchase price is negative, it will involve considerable transportation cost.

The price in fuel in India is based on the average of the prices of Brent, Dubai and Oman crude prices, and WTI price is not a factor in it. Therefore, the negative pricing in the USA will not have any effect on the Indian market.

Although the price of the Indian oil basket is also low at present, as there is a global glut in the oil market, the prices should come down when those low crude prices start reflecting in retail prices. That is unless the govt decides to raise taxes to maintain a stable price and to help in tax collection which is already very low due to the ongoing lockdown.

Shashi Tharoor is an MP and a former union minister, and he is expected to know what kind of oil India buys. But in an effort to target the Modi government, he kept aside facts and demanded that Indian consumers should get the benefit of negative price in the USA.

 

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OpIndia Staffhttps://www.opindia.com
Staff reporter at OpIndia

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