Uncharted Territories: Oil Prices & The Sensational Plunge

As if the dizzying headlines around various segments of the stock markets were not enough, today our headlines are flooded with news about crude oil prices going below $0 and people wondering if everyone gets free petrol?

What’s the word on the street?

The price of benchmark U.S. oil (West Texas Intermediate) nosedived to a price-point below $0/barrel – not just negative but a negative as deep as -$37.63. This happened for the first time ever. This time was actually different, for a change – the steep decline in prices came in through a combination of demand & supply shocks.

Prices went negative – in essence, anyone trying to sell a barrel of oil would essentially need to pay the buyer $37.63 at a point in time, to take the barrel of oil from the seller’s hands.

This has a lot to do with the way oil is traded

Can I go to an oil company now and ask them to pay me to buy oil from them?

Unfortunately, that’s not how this works.

First things first, you must understand that the plunge is in the price of futures contract which is a financial instrument that reflects the price of oil. A futures contract is basically an agreement between a buyer and seller to buy and sell a certain quantity of oil at a particular price at some point in future (called the expiry date). The price of oil is decided basis its market price on the expiry date.

Now, there are two ways a futures contract can go – either net settlement or physical delivery. For instance, let’s say you are a trader and not really in the business of oil and today you enter into a contract to buy certain units of crude oil at $40 and on the date of expiry the price of crude oil for the same quantity goes up to $60, there’s a notional transaction presuming that the seller would have to buy at $60 on the expiry date and sell it to you for $40 thus incurring a loss of $20 – hence, he will simply pay you the $20 you were to gain and the seller was to lose.

Now, every contract needs to be backed by an actual, real quantity of crude oil stored someplace. If the buyer requests a physical delivery of the contract oil, he should be able to collect it from a storage facility. Now, here’s where things got tricky.

What’s the story?

In a line, oil markets started reacting to reality instead of free-floating reports & viral tweets.

Cut to the chase – futures contracts requiring buyers to take possession of the underlying barrels of oil expired on 21st Apr’20 and none of the buyersseemed to want the oil. Why, you ask? Simple, there’s no place to store it.

Now, slow down a bit for a moment and let’s re-think of the dynamics & drama that unfurled in the crude segment in the past couple of months. Saudi Arabia & Russia’s fallout led to a price war where they both decided to flood the market with more oil; U.S. retaliated by continuing to produce oil – this led to the first leg of decline in oil prices led by a supply glut. Episode two began with the slowdown in global consumption as the pandemic brought global trade & commerce to a standstill with the demand for oil coming to an almost staggering halt – a negative demand shock. These two led to the reality that most were unable to see coming – too much inventory and no way to get rid of it while paying for its storage throughout.

To offer perspective into the severity of the storage problem, the world has an estimated storage capacity of 6.8 billion barrels and apparently, 60% of it is expected to be full. Cushing, Oklahoma is a critical storage hub where oil that trades on the U.S. futures market is stored. The hub has a massive storage capacity of 80 million barrels, but interestingly it is expected to be holding 59 million barrels of oil already; which leaves it with only ~25% of unutilised capacity which is expected to be completely utilised by May’20.

If things continue, it could be only a matter of days before the storage facilities at Angola, Brazil, Nigeria, Caribbean and South Africa run out of space.

Now, one must also take into consideration the fact that as the world runs out of storage space, like any other commodity, the cost of storage is only going to increase – which will iteratively increase the carrying cost and perhaps continue exerting a downward pressure on the already negative oil prices.

Why don’t they just stop producing and wait till the current inventory is used up?

If this thought crossed your mind, trust me you’re not alone. But, let me help you regain confidence in the world’s collective intelligence – life in the oil arena is not as simple as switching the machines off and later switching it on when needed.

For starters, let’s consider the fact that economies like Saudi Arabia, Russia and perhaps every other OPEC participant relies heavily on crude oil to run their economies – now, they may not be very forthcoming in cutting production to zero as they also (like the world) wade through the pandemicstruck economic slowdown.

Next, rigging oil wells is not just an operational nightmare but also relies a lot on the whims of Mother Nature. It is not that an oil explorer can simply strike his shovel into the ground anywhere and black gold gushes out like they’ve telecasted on many cartoon series. Rigging requires a lot of labour, technology, machinery and a little bit of luck to hit the right spot and yet, there’s always the quality roulette. If explored fields are simply covered and left unattended, it may not just affect the quality of oil but also the quantity of the already-exposed crude to some degree.

Also, considering that machinery and skilled manpower comes at a heavy cost, getting back into the game could turn out to be a rather costly affair as machinery depreciates & skilled labour becomes costly.

Also, for the create minds wondering if it could simply be dumped – the answer is no! Dumping into landfills or the ocean could cause serious environmental damage and attract penalties almost the size of most companies’ balance sheets. Besides, I’m sure nobody wants an environment crisis right in the middle of a health and economic crisis.

So, what next?

You weren’t entirely wrong if you were thinking about totally shutting operations, the idea is to trim production just enough that it does not overflow from the storage.

The OPEC+ has decided to cut production by 9 million barrels per day which accounts for around a tenth of global supply volumes. While the intent and action are appreciated, the impact of this production cut may be muted if analyst expectations that demand will reduce by 29 million barrels per day materialises. This means that demand will drop by a quantum of more than 3x of the committed supply cut; this does alleviate the problem but does not really solve it meaningfully. Analysts expect U.S. oil production to reduce by ~2.3 million barrels per day to 11 million barrels per day, YoY, by the end of this year.

Sure, like the adage goes – ‘If you’re important to the economy, the government is your largest customer when you don’t have any’.

Trump administration spoke about absorbing 75 million barrels into the Strategic Petroleum Reserve. But, we have our doubts on the efficacy, especially in light of the understanding that the reserve already has ~650 million barrels of oil reserves and cannot accommodate anything over additional 75 million barrels and operationally, the reserve can accept up to 500,000 barrels in a day – this equates to almost 150 days to get the transfer done.

Obviously, the production cut along with an uptick in economic activities in any quantum would take oil prices a step closer to stabilisation, albeit gradually. Let’s hope that something moves in the right direction quick; an additional budget by the U.S. Fed to contain a credit default contagion sparked by highly leveraged oil companies could be a real blow to the already hurting treasury.

How’s India placed?

Just to clear the air, India buys Brent Oil (which is traded and supplied in economies outside the U.S.) trading at $25-$30 ranges and not the West Texas Intermediate which entered the negative territory.

For those wondering – “Why don’t we just buy WTI?”

For academic purposes, let us consider that India goes through the rigmarole to sign up new contracts for the WTI and change suppliers to benefit from the low prices; also presuming that the longer routes to WTI storage hubs would lead to incremental cost of transportation but still explore a possibility that the fully-loaded cost is yet lower than Brent. The immediate question is – if the world is running out o storage space, does India have enough to hoard excess? Maybe not. Indian Strategic Petroleum Reserves programme can accommodate 36.92 million barrels of oil – which is typically 10-days of Indian consumption (obviously, pre-lockdown). India has also leased some storage to international oil producers who store their oil there. On a brighter note, the storage business today actually seems to
be more lucrative than the oil business.

While Brent crude futures have not fallen as sharply, it sure has dropped by over 60% in 2020, till now.

By now, most would have understood the indicative relationship between the price of crude oil and India’s import bill, courtesy recent bouts of volatility in oil prices and tireless media coverage. For the uninitiated, a single dollar drop in prices of crude oil per barrel reduces India’s Import bill by almost INR 10,700 Cr. As a standard, it is expected that India saves ~0.5% of its GDP worth of external payments with a $10 drop in oil prices.

With India importing almost 80%-85% of its crude oil requirement, the government could definitely stock up now on cheap fuel to benefit from a lower import bill, surplus cash in the treasury, lower inflation (not a great thing right now, though) and the ability to increase tax revenues from the enhanced headroom once consumption restarts.

If Brent prices remain in current ranges, we can expect Indian equities to benefit as the currency appreciates on the back of a healthier treasury.

Key takeaways for investors

Indian equities may seem jittery for a while but that can be majorly attributed to it taking cues from and a ripple effect led by global markets more than anything else. In fact, if India gets back in business while oil prices remain at current levels, it stands to benefit not only the economy but also companies & its shares operating in the economy.

While we do not recommend any tactical play basis the movement in oil prices, our view on Indian economies continues to remain at an “accumulate on declines” stance with a bias towards equities of large-cap companies.

[tek_button button_text=”Download Fisdom App” button_link=”url:https%3A%2F%2Fbit.ly%2F3623jP0||target:%20_blank|” button_position=”button-center”]

Join our Fin Insight Community