Why Crude Oil Prices Crashed: Top 5 Reasons For It

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Crude-oil-price-crashes-to-negative-what-does-that-mean

The year 2020 has already been in highlights due to ongoing novel coronavirus outbreak as it has wreaked havoc across the world and severely impacted the global economy. 

On 20 April 2020, in a historic drop, the crude oil prices plunged below zero US dollars. Crude oil prices hitting negative was unimaginable.

What comes to your mind when you hear the price of any service or commodities is negative?

I have a very subtle example to illustrate this situation. But let’s learn a mild economic concept before that.

What Are Demand and Supply?

Demand: Demand refers to how much of a product, service, and commodity, a consumer is ready to buy backed with sufficient purchasing power. Here, don’t confuse desire with demand both are different. 

Supply: It refers to how much of a certain product, service, or commodity, a  supplier is willing to make available at a particular price. 


equlibrium-of-demand-and-supply

Now, both supply and demand are economic forces of the free market that control the prices of goods in the market; either at the micro-level or at the macro level. The point where both supply and demand intersect is called equilibrium.

Example:
In IPL auction, analysis of the demand for a particular skill in a team and how much team owners are willing to pay for that skill decides the bidding price of a particular player. Hence, there are simple laws when the demand for any commodity rises its prices also rise, and simultaneously its supply falls due to scarcity of resources that balance its price at a point of interaction.

Thus, in this manner market is stabilize itself to maintain profit and loss. 

Now come back, what if the price related to any commodity is negative?

We have seen a Negative Interest Rate Policy in the banking system. Under this policy, the depositor has to pay interest to the commercial banks for holding their saving instead of commercial banks paying them the interest for their deposits. Similarly, a negative interest rate occurs when borrowers are credited interest rather than paying interest to lenders. 

Countries like Japan, Sweden, Denmark, and Switzerland have used these policies to encounter their economic downfall.


What does Negative Crude Oil price mean?

As demand hits rock bottom and storage tanks filled up, for the first time in history reveals how badly the market has been impacted by the pandemic outbreak. The negative price of crude oil indicates that companies must now pay a buyer or customer to take oil off their hands. As the storage capacity has been exhausted, selling at any cost is the only option left with the producers.


graphic-presentation-of-fall-in-crude-oil-prices

Donald Trump also announced that he is planning to add as much as 75 million barrels of oil reserve in the existing strategic petroleum reserve. 

Note:
1 barrel = 159 liters 
1 Liter   =  70 Rupees approx. (Indian Market Price)
159 L    =  11,130 Rupees appox.

One Look On Tweets:


Top 5 reasons for the fall in Crude oil price.

1] Lockdown:

More than half of humanity is under lockdown. No one is allowed to leave the place they are at. Only the essentials supply chain is active comprising of grocery stores, pharmacies, and banks. This lockdown has taken many non-essentials industries by storm, especially the transport industry, be it roadways, airways, or seaways. Consequently, there is a downfall in demand for oil across the world.

2] Saudia Arabia- Russia Price War: 

Since the beginning of the year, the price of oil is continuously varying because of the ongoing price war between Saudi Arabia, Russia, and the US.

Prices of oil in the market are always volatile, meaning it is high at one instant and low the very next instant. That is why most of its dealing takes place through future contracts. However, this volatility became highly unpredictable due to the ongoing price war between Russia, Saudi Arabia, and the US. The OPEC+ nations decided to reduce the production against the fall in demand but Russia breached all the agreements and produced more oil to shake the market for a shorter period to harm other oil-producing countries internationally, mainly the USA. This caused oversupply in the market which ultimately led to the crash of price.

3] May Future Contract: 

The drastic fall in crude oil demand triggered the tension between the buyers, as their reserves are more than topped up to meet the current demand. This reckoning belief that future demand won’t be as high as it used to be mass of the importer across the world didn’t even put in a bid for May purchase which ultimately led to the crash in prices.

NOTE:
Future contract: In finance, a futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other.

4] Storage Problem: 

As there are less consumption and continuous supply, the world is running out of space to store crude oil. Capacity can be outstretched to some extent but it further adds up to cost. If in this crucial period of pandemic average variable cost(AVC) overlapped the average cost(AC), that will eventually lead to the wind up of many small businesses, as they won't be able to absorb this financial shock.

NOTE:
Average Cost refers to the average cost of whole production operation including fixed and variable expenses.

Average Variable Cost refers to the average cost of whole variable nature expenses like electricity, labour, raw, etc. 

5] Commercial travel bans: 

During recent weeks, many countries around the world have imposed travel restrictions to help curb the spread of the COVID-19. The aviation and rail industry is suspended. 90% of vehicles are now off the road that backfired the oil industry.  


Understand the types of crude oil traded in the market.

There are varieties of crude oil that are produced from different countries. To serve the buyers and sellers of crude oil prices, a certain benchmark came into existence. There are three primary benchmarks.
  1. WTI (West Texas Intermediate)
  2. Brent Blend 
  3. Dubai/Omen crude. 
Location-of-major-crude-oil-benchmark-producing-nations

West Texas Intermediate (WTI)-

Location: WTI refers to the oil extracted from wells in the United States. The Shale Revolution of the early 2000s in the US oil industry escalated the supply during this period made the U.S. one of the key market players.

Quality: It contains a very less quantity of sulfur making it very sweet and light and ideal for gasoline refining.

Market/trading: It is drilled from the soil and sent via pipeline to Cushing, Oklahoma. Oklahoma is a trade hub for further supplies across the globe. Due to transportation by road, it becomes more expensive.


Brent-

Location: Brent crude oil mainly extracted from four different oilfields in the North Sea Brent, forties, oseberg, and ekofisk. However, this oilfield named after a bird Brent goose.

Quality: It contains a little higher content of sulfur make it less light compared to WTI and ideal for refining into gasoline, diesel fuel, and other high demand products.

Market/trading: As it is waterborne, supply across the globe is very easy to distant location; roughly two-thirds of all crude contracts around the world refer to Brent crude.


Dubai/Oman-

Location: This grade crude oil covers all the Middle East countries from Dubai, omen, or Saudi Arabia.

Quality: It contains a higher amount of sulfur which makes it much heavier and sour.

Market/trading: Dubai/omen benchmark influence the Asian crude oil market. It is generally used for pricing Persian Gulf exports to Asian.

How will this oil price crash affect India?

India, the world’s third-biggest oil consumer will not be benefitted from the oil price crashes. India almost owns at least 66,000 petrol pumps which are currently at the risk of overflowing as the nationwide lockdown has restricted consumption. So, when there will be no demand, it will not have much impact simply because we are not going to buy much crude, especially in a shorter period. However, India fulfills most of its consumption through supplies from Middle East countries where the prices are not as down as in WTI. Eventually, even if govt. earned some financial benefit they surely want to utilize it to encounter the current pandemic crisis. 

Must Read:

Coronavirus Outbreak: Everything You Need To Know...


10 comments:

  1. Everything is explained with the use of best possible economic reasons behind them.Amazing Work❤👍.

    ReplyDelete
    Replies
    1. Thank you. Application at macro level is priority.

      Delete
  2. Very nice analysis. As all airlines have stopped functioning due Lockdown the demand of oil has suddenly decreased. Not only planes but cars buses all have decreased demand. Good analysis.
    Dr Nishikant Sharma MD

    ReplyDelete