why-are-oil-futures-in-negative-terrain-summary

Context:The United States oil markets created history recently when prices of West Texas Intermediate (WTI),fell to “minus” $40.32 a barrel in interlay trade in New York.

More about the news:

  • It was the West Texas Intermediate (WTI) price for May in the US markets that went so low. Crude oil prices elsewhere fell too but not this low in comparison with the WTI prices.
  • A negative price implies that a seller would have to pay the buyer to hold the oil to be supplied.
  • This is the second instance when oil prices have fallen below the zero mark,first of such incidents was immediately after World War II.

Reasons behind this situation(Too much supply and too little demand of oil)

  • COVID-19 and slowdown in economic activity:
    • Growing spread of novel coronavirus disease is sharply reducing economic activity and the demand for oil.
    • For limiting  the spread of COVID-19 countries have imposed lockdown. Which has resulted into fewer flights, cars and industries etc. using oil
    • This has resulted in faster shrinking of demand for oil in comparison with the oil production cuts by various countries.
  • To cancel out negative outcomes production cuts: 
    • Cutting production or completely shutting down an oil well is a difficult decision, because restarting it is both immensely costly and cumbersome.
    • If one country cuts production, it also risks losing market share if others do not follow suit.
  • Earlier disagreement of Saudi Arabia and Russia over the production cuts:
    • As a result of the disagreement,oil-exporting countries, led by Saudi Arabia, started undercutting each other on price while continuing to produce the same quantities of oil.
    • This has contributed to excess supply of the oil.
  • Exhausted Storage capacity
    • By the time the discord between Saudi Arabia and Russia was sorted out last week, under pressure from the US,it was possibly too late.
    • Land storage in America is already overflowing.Floating storage is also fast running out of capacity
    • Trains and ships, which were typically used to transport oil, too, were used up just for storing oil.
  • Desperation from holders of the delivery contract and the oil producers 
    • For both of them it was less costly to pay $40 a barrel and get rid of the oil instead of storing it (buyers) or stopping production (producers).

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Future of oil prices:

  • Association with the lockdown period:
    • With COVID-19 continuing to spread, global oil demand is falling every day. In the coming quarter, some estimates claim that total demand will fall by 30%.
  • Dependence on cutting oil production:
    • With storage for crude — on land or offshore in supertankers — nearing capacity or becoming prohibitively expensive, oil producers are going to have little option but to curtail output.
  • Probable implications of inadequate production cuts in new agreement:
    • Recently Organisation of Petroleum Exporting Countries, along with Russia have agreed to cut crude oil output by 9.7 million barrels per day to bring down supply. 
    • But this cut is unlikely to be enough to readjust supply given the extent of the collapse in global demand. 
  • Ultimately it would be the demand-supply mismatch (adjusted for how much can be stored away) that will decide the fate of oil prices.

Probable implications on India

  • No direct impact:
    • The Indian crude oil basket does not comprise West Texas Intermediate (WTI).
    • It contains only Brent and oil from some of the Gulf countries so there is no direct impact and it may not translate into a sharp lowering of prices at retail pumps for consumers in India.
  • Indirect impacts:
    • As oil is traded globally so weakness in WTI may get mirrored ultimately in the falling prices of the Indian basket as well.
  • Boost in individual consumption:
    • If the government passes on the lower prices to consumers, then, whenever the economic recovery starts in India, individual consumption will be boosted. 
  • Implications on Government revenues:
    • If, on the other hand, governments (both at the Centre and the states) decide to levy higher taxes on oil, it can boost government revenues.
    • The oil import bill will fall sharply this fiscal year, giving tremendous relief to the government on the external account front.
    • With oil prices falling and foreign exchange outgo reducing, the pressure on the current account balance is off.
  • May not be able to fully reap the benefits:
    • This may be the result of dearth of crude oil storage capacity.
    • While India has a storage capacity of 39 million barrels, China’s total capacity is at 550 million barrels and Japan’s at 528 million barrels.
  • Impact on remittances
    • As lower oil prices will impact the economies of oil producing countries in the middle east, they could also affect remittance flows to India.
  • Implications on OMCs:
    • Experts say OMCs are making up for inventory losses and reductions in refining margins due to a drop in demand by as much as 70 percent due to the lockdown
    • Due to this it is unlikely to have lower prices in response to the fall in crude prices until demand for fuel recovers.

About West Texas Intermediate (WTI):

  • West Texas Intermediate (WTI) crude oil is a specific grade of crude oil and one of the main three benchmarks in oil pricing, along with Brent and Dubai Crude.
  • It is the world’s most traded financial oil contract, a benchmark followed from Zurich to New York to Tokyo.
  • It is the American benchmark for crude oil.
  • WTI oil is traded as futures contracts in the NYMEX (New York Mercantile Exchange).
  • Here traders buy and sell monthly futures such as, for instance, May futures, June futures and so on.
  • The sellers of such futures will have to deliver a barrel of crude oil at the contracted price in the contracted month just as buyers will have to take delivery at the contracted date.

Comparing Brent Crude with WTI

  • Prices:Brent oil has traditionally quoted higher than WTI, with the gulf being about $6-7 a barrel between the two. 
  • Quality:Brent is a superior grade produced in the North Sea off the British coast and is the accepted benchmark for this part of the world. 
  • Market:The market that it serves is considerably larger than that of the United States and demand is, therefore, higher. 
  • Refineries in Europe are configured for Brent, rather than WTI. Prices of Brent are, therefore, always higher than those of WTI.
  • Transporting oil from the U.S. to Asia is not economical, thus limiting the scope for the WTI grade. 

 

Oil Pricing in India

Indian basket of crude oil

  • The Indian basket comprises Sour grade (Oman and Dubai average) and Sweet grade (Brent dated) crude oil in a 76:24 ratio.

Parity Pricing

  • While determining petrol and diesel retail prices, OMCs in India consider trade parity pricing, which is determined on prevailing prices of these products in the international market. 
  • The pricing formula incorporates 80 per cent of the import price and 20 per cent export price of the fuel. 
  • After that, other inputs such as dealer commission, excise and state levies are added to the trade parity price.


 

About India’s strategic oil reserves

  • India is building up its strategic reserves, taking advantage of the cheap prices. 
  • Indian Strategic Petroleum Reserves Ltd (ISPRL) is responsible for building and filling of SPR sites.
  • India has a capacity to hold over 39 million barrels of oil at its strategic reserves.
  • Locations of strategic reserves: Vishakhapatnam, Mangalore and Padur, near Udupi
  • These are underground salt caverns converted and built to store crude oil. 
  • The strategic storage capacity is now being increased even as the existing caverns are being filled.
  • Though India approved construction of two new caverns in 2018, as part of its phase two expansion, in Chandikhol in Odisha (4mt) and Padur II in Karnataka (2.5mt), work is yet to commence on these project.
  • In comparison, each IEA country has to hold emergency oil stocks equivalent to at least 90 days of imports. India should be working on similar lines.


 

OPEC

It is a permanent, intergovernmental organization, headquartered in Vienna, Austria.

  • Founder Members: The Organization of the Petroleum Exporting Countries (OPEC) was founded in Baghdad, Iraq, with the signing of an agreement in September 1960 by five countries namely Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. They were to become the Founder Members of the Organization.
  • Currently, the Organization has a total of 14 Member Countries.
  • OPEC’s objective is 
    • to coordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; 
    • an efficient, economic and regular supply of petroleum to consuming nations; and 
    • a fair return on capital to those investing in the industry.
  • OPEC membership is open to any country that is a substantial exporter of oil and which shares the ideals of the organization.

OPEC+

About 

  • OPEC+ refers to the alliance of crude producers, who have been undertaking corrections in supply in the oil markets since 2017.
  • OPEC plus countries include Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan.
  • The Opec and non-Opec producers first formed the alliance at a historic meeting in Algiers in 2016.
  • The aim was to undertake production restrictions to help revive a swinging market.

Sources:

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