Having seen roller coaster markets over the course of this current crisis, it was going to take something exceptional to really grab the attention this week, and that is exactly what happened when US oil prices turned negative on Monday night. While it is important to remember that the oil price is not universal and that the negative price was for a very short dated contract for delivery of West Texas Intermediate (WTI) in May, the fact remains that on Monday evening traders were effectively paying to get rid of the commodity. The question is why this may have happened and, from a broader market perspective, what this may indicate about the state of the global economy.
As stated above, the negative price was for WTI, which is the main oil grade in North America, and the May contract which expired on Monday evening. With commodities, as opposed to stocks and shares, you are trading something physical and if you own the contract when it expires, you have to collect the product. In normal circumstances this is very much a technicality because although the price may fluctuate, all the supply will be used, the traders bet being that the price of the contract will either rise or fall depending on the relationship between supply and demand. However, with economic activity at a near standstill due to the varying degrees of lockdown in the world, demand for oil has plummeted and there is too MARKET UPDATE 25th APRIL 2020 much supply. In the short term this has become extreme resulting in a glut of oil which has to be stored somewhere until demand returns. As storage facilities, including oil tankers as well as onshore facilities, are at near capacity, the cost of holding oil has soared with the end result being Mondays unprecedented scenario of people being paid to take delivery. The May contract for WTI was trading at $18.27 as recently as the previous Friday, but fell from $10 at the open on Monday to minus $40.32, although it did rebound to around zero.
It should be remembered that it was a very specific set of circumstances that led to Mondays situation, indeed the contract for next May (2021) was trading at around $35 while this was all happening, but it does illustrate how dramatic the economic slowdown has been. Despite the recent deal between Russia and the Saudis to limit supply during the slow down, it still outstrips demand and this is reflected in the broader price of oil. Brent crude fell 22% in the week and is now trading at under $22 per barrel, well below the $40 to $50 price that most feel to be the price producers need to break even. Many oil producing countries are politically unstable and a prolonged slump in the price could have far reaching consequences. When economies take a down turn in normal circumstances demand for oil tends to drop anyway, but COVID 19 has an additional dimension which is adding to the problem. On top of the industrial slow down and consequent fall in demand from that sector, travel is practically non existent and millions of people who would normally be commuting are now working from home. All these factors are having an unprecedented effect on demand, which some analysts feel could drop by 20m barrels a day in May and June.
What does this tell us about the broader economy ? As with everything in the current situation it all depends on the speed at which we are able to exit lockdown and return to some degree of normality. The wild price fluctuations can be seen as reflecting the hope that better news on infection and death rate is imminent, followed by the reality of holding a product that no one wants until there is recovery.
It seems important to try to end on a more positive note and so I will. We know that this situation will pass, be it through a vaccine or the more controversial herd immunity scenario, and when the economy does reopen the glut in oil will suppress prices for a while. This will mean cheaper oil which will be a real boost for the economy, accelerating the recovery. While not great news for oil companies – and here one should consider that the FTSE has a distinct weighting to this sector – it would help the broader economy.
Author Trevor Hubner