Wednesday 22 April 2020 12:20 pm

Analysis: Why oil prices turned negative, and might do again

On Monday night oil prices turned negative for the first time in history, as traders started paying to have barrels of oil taken off their hands due to the total collapse in demand caused by coronavirus.

The unprecedented scenes were a result of a number of coalescing factors which created a situation in which buying oil storage was more expensive than oil itself.

Read more: FTSE 100 falls after US oil price turns negative for first time

With storage getting ever closer to capacity, a similar situation could occur again further down the line as traders become desperate to offload the commodity again.

The collapse has also led to concerns that a similar sell-off might be in the offing for Brent crude, the global benchmark.

Why did oil prices turn negative?

There are around 9,000 domestic oil producers in the US, who are currently being hammered by the price collapse. (AFP via Getty Images)

The fundamental reason why prices turned negative is a straightforward one, as Rachel Winter, associate investment director at Killik & Co, says:

“Nobody wants to take delivery of oil next month because there’s nowhere to store it”.

However, as James Trafford of Fidelity International says, “Yesterday’s price action is best understood as a quirk or peculiarity of futures trading – one that has been made much more extreme by the current situation”.

Oil futures are contracts to actually deliver the commodity in question to a specific location for a specific date.

Monday’s price action came about because the WTI May contract expired yesterday, meaning that anyone in possession of a contract would have to take delivery of the commodity at the main WTI storage facility at Cushing in Oklahoma on the set day in May.

Normally, if traders do not want to take delivery, they can simply sell the contract or roll it over to the next month.

However, because of the enormous supply glut and rapidly growing shortage of storage space, no one wanted to buy up the contracts – leading to a situation where traders were being paid up to $37 to take them on.

Read more: US oil price turns negative for first time ever

Neil Wilson, senior markets analyst at markets.com, said: “What we got was a severe dislocation as paper traders found they had to offload positions without any liquidity or bid in the market. 

“A unique event, but one that reflects how financial markets can become very dysfunctional very quickly when things go bad”. 

Will prices collapse again?

Oil Prices Trade In Negative Numbers For First Time Amid Global Oil Glut
Prices turned negative for the first time in history last night as traders were desperate to get rid of oil delivery contracts due to record demand lows and limited storage space. (Getty Images)

Now that the May contract has expired, the new “front month” – the month of delivery – is now June. 

Having been trading at around $20 per barrel, June prices plunged to $10 amid the growing realisation that storage space has all but run out.

With no uptick in demand expected, a sell-off on the same scale could be in order, unless a solution to the supply glut is found.

Listen to our daily City View podcast as we chart the economic fallout and business impact of the coronavirus pandemic.

Charalambos Pissourous of JFD Bank said: “With the restrictive measures still intact around the globe, we cannot rule out another round of selling as demand remains subdued and storage space continues to diminish. 

“Even if some nations decide to start loosening their lockdown restrictions, this may be a very slow procedure, and thus, demand is very unlikely to return to its pre-virus levels soon”.

Read more: Analysis: Can oil prices recover from the coronavirus crash?

According to Morningstar, capacity at Cushing will reach its limits in mid-May, which will only exacerbate the problem when the June contract expires next month.

Could Brent crude also go negative?

After the WTI collapse, attention naturally turned to worldwide benchmark Brent crude to see if it would follow suit.

Although it has not yet collapsed to the same degree, Brent futures for May and June are trading at $13 and $17 respectively, and a further fall is very much a possibility.

Rystad Energy analyst Louise Dickson said: “Brent is not immune to a negative price possibility. What happened to WTI can happen to any traded commodity, if the forces behind the short are aligned.

“This explains the negative sentiment around Brent today, which is also falling by a wide margin. Traders have realized the danger and thus the sell-off that is observed today”.

However, she went on to say, Brent crude “should be more resilient”:

“Brent is made up of multiple crude grades and has natural egress to seaborne markets, and thus can chase global demand in a way that WTI cannot.

“There are also fewer players with a vested interest in seeing Brent collapse – Saudi and Russian crudes are both unofficially pegged to Brent, for example”.

Wasn’t the Opec deal meant to protect prices? 

TOPSHOT-KUWAIT-GULF-MARKETS-HEALTH-CORONAVIRUS
Opec’s price protection deal to cut output by record levels has not gone far enough to prop up the struggling market. (AFP via Getty Images)

Earlier this month oil cartel Opec struck a deal with Russia to reduce oil output by 9.7m barrels a day, nearly 10 per cent of global production, in a bid to prop up the market.

However, the record deal (the previous largest cuts Opec had agreed, during the 2008 financial crisis, were a mere 2.2m barrels) has proved ineffective for two reasons.

First, the collapse in demand for oil has fallen as much as 30m barrels a day in April, according to the International Energy Agency (IEA).

It will fall by roughly 26m barrels in May, leaving an enormous output overhang despite the cuts.

In addition, the cuts do not actually come into effect until 9 May – a full month of production after they were first agreed.

According to the Economist Intelligence Unit, gasoline stocks in the US have already passed 262m barrels, their highest ever levels.

In the meantime, tanks have continued to fill around the world. Paola Rodriquez-Masiu of consultancy Rystad Energy said it was important to remember that supply capacity is not even around the world. 

Big producers, which export the majority of their oil, tend to have far less storage space than importers.

Read more: US oil prices plummet to 21-year low as demand dries up

There has been a rush among petrostates to lease extra capacity on tankers to cope with the glut.

According to Rystad Energy, a production shutdown of 5m to 7m barrels a day will be required if storage is not to surpass its limits.

Share:
Tags: