Is the Oil sector on the brink of breakdown?

Life across the globe came to standstill amid COVID 19 pandemic which has destroyed the demand for Crude Oil. Hence, decline in crude oil prices over the last few weeks should not be a surprise for many people. However, in an amazing move this Monday, for the first time, WTI Crude oil prices have crashed below $0 and triggered curiosity that how an asset class instrument can go into negative zone.

In the recent past, most of the oil refiners have reduced their final production and some refiners have closed their operations completely to adjust the supply to the demand. Plunge in oil prices has made most of the oil producers and refiners to accumulate oil in their spaces so that they can sell their output post-pandemic. On the other hand, extraction of oil has continued and the storage capacity of both producers and refiners started to shrink. Storage capacity is limited.

The exchange-traded price indicates the economic value of the instrument minus any operational or storage costs.

Most of the instruments traded on the exchange are in the derivatives segment, which implies on expiry of the contact has to be taken for delivery. West Texas Instrument (WTI Crude Oil) contracts traded on NYMEX have to be taken for physical delivery on the expiry of the contract. On Tuesday, May month deliverable contract expires, a day before (Monday), all contracts outstanding shall be marked for physical delivery. Most of the participants who traded the contract aren’t refineries or have no intention to mark for delivery, while even contracts that are marked for delivery also need to be physically delivered at Oklahoma (US).

The storage scarcity at Oklahoma and increased costs for storage made traders get rid, unwind, and junk off May contracts at any cost with others moved to June contracts. Said in other words, storage cost for one month is higher than the spot price and long position holders while unwinding is ready to pay to take off the commodity from their hands. While offloading the May contracts, the spread between May and June or, the “contango” (the cost difference between future date deliveries versus the present date delivery) has risen to almost $60.

WTI supply is landlocked and has higher logistical costs, which is the reason for WTI Crude trades at a discount to Brent Crude Oil. Intercontinental exchange-traded Brent Crude oil was trading in the range of $20 to $25 per barrel on Monday, indicating still some storage space is available outside the US.

Even after the US and OPEC have decided to cut 10 million barrel production per day, but the shutdown and global slowdown have kept oil prices in a downward spiral. It’s not just easy to shut and reopen the production whenever required. Hence, production will continue and demand has declined. Currently, the Oil industry is grappling with both demand and supply-side issues, and more decline in prices may trigger a collapse of high-cost production companies and countries.

The reduction in production and series of shutdowns will have a huge impact and shall create a fresh downward spiral of the energy sector. Decline in crude oil prices will have impact on jobs, companies and banks which have lent to these companies. Oklahoma Oil regulator has allowed some rigs to shut down and the same sort of decision is also taken by Oklahoma’s neighboring state New Mexico. Shutting of oil wells or stopping production is a herculean task and precautions have to be taken so that future production is not damaged. Russian companies have also announced that they shall reduce their exports. Apart from producers, we are witnessing a series of refinery units getting idled or would stop their production. Oil Majors like Royal Dutch Shell Plc, Marathon Petroleum Corp has announced that their units shall work at half run rate. Going forward, for now, June contracts have started to decline after hitting a top at $18 per barrel and may slip further if the current lockdown continues. When economic activity is back, it shall trigger demand and uptick in price.


Reference

https://www.eia.gov/petroleum/supply/weekly/

https://www.eia.gov/petroleum/data.php#crude

https://www.eia.gov/petroleum/data.php#refining

https://www.api.org/products-and-services/statistics/api-weekly-statistical-bulletin

https://www.reuters.com/article/us-oil-usa-oklahoma-cuts/reeling-oklahoma-oil-producers-win-right-to-keep-leases-while-wells-shut-idUSKCN2242DR

https://in.reuters.com/article/russia-oil-exports/russia-halves-western-sea-oil-exports-in-may-after-opec-deal-idINKCN2262GR

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Professor Syed Hasan Jafar has over 10 Years of Experience in the field of Finance and worked as a Research Analyst and Corporate trainer. He comes on several national media channels as a financial expert for sharing his view on the financial market. His areas of expertise are Security Analysis, Corporate Finance, Equity, and Derivative Research and Wealth management. He completed his bachelor’s degree in Science from the University of Bangalore, his post-graduation Diploma in management from the Institute of Public Enterprise (IPE). He is NISM Certified Research Analyst. His areas of expertise are Security Analysis, Corporate Finance, Equity, and Derivative Research and Wealth management. He has conducted more than 50 Investor awareness programs across the country and has been awarded Best Research Analyst several times.