COVID TurmOIL - Big Blow to Crude Markets Explained

For a brief period on 20th April 2020, West Texas Intermediate (WTI), a grade of crude oil used as a benchmark in oil pricing, plummeted to NEGATIVE $38 a barrel. Yes, a barrel of oil was cheaper than a Starbucks coffee. Oil producers ran out of space to store the oversupply of crude left by the corona virus crisis, triggering this historic market collapse which left oil traders reeling.

It means that if you were to "buy" a WTI May Futures contract (an order for a thousand barrels of oil, delivered to a specific location on a pre-decided future date), you would be "paid" $38,000. A WTI Futures contract mandates that whoever buys the contract has to collect the barrels of crude from Cushing, Oklahoma, the United States, where energy companies store their oil in a facility that has a storage capacity of roughly 75 million barrels.

Why had this nosedive in oil prices not prompted people, firms and governments alike to rush and "buy" this precious commodity? Well, the situation was a little more complex than that. Before we explain why negative oil prices are not necessarily a good thing, let us first dive into the intricate world of this valuable commodity they call black gold.

What causes the crude prices to fluctuate?

Just like any other commodity, oil prices are also driven by the market forces of demand and supply, as shown in the above figure. However, the law of demand holds in case of ceteris paribus, that is, with everything remaining constant. In fact, since the last three months, nothing seems to have been constant. The current global pandemic has a huge role to play in defying the law of demand shown above.

With a general decrease in demand following global lockdowns and ban on travel, the demand for oil went down automatically. This, combined with an oversupply of the commodity led to a steep fall of crude prices for a brief period, in the month of April.

Apart from the exogenous factors of demand and supply, the global oil prices are sensitive particularly to the clout of the Organization of Petroleum Exporting Countries (OPEC+).

OPEC+ which produces 40% of the world’s crude oil, is a cartel that is a group of 14 of the worlds major oil-exporting nations shown in the above picture.

Now that you understand why the prices of unrefined oil oscillate, let us look at the two most popularly traded grades of oil being WTI and Brent Crude.

Brent vs WTI

There are two most discussed indices namely WTI and Brent crude. While Brent crude is extracted from the North Sea, Europe, WTI is taken out from the US oil fields of Texas, Louisiana, and North Dakota. The price which hit below $0 per barrel, lowest in its history is mostly part of the US oil market. Though Brent Crude prices were higher than WTI, both prices were the lowest in almost 20 years. The cost of Brent crude was higher and in the positives, since they had more storage available cross several locations, making deliveries easier.

With the sharpest fall in the oil prices since the Gulf war in 1991, you might expect air carriers to be popping champagne corks, but was that the case?

BOON or BANE for Airlines

Fuel costs are one of the poignant expenses for the airline industry. On average fuel costs account for 25% of all airline expenses, which is equivalent to approximately 20% of operating revenues.

The currently low crude price will make the cash strapped airline industry operate flights at good profits if they fly at their full capacity.

Since there is a stiff competition in aviation, even small bumps in oil prices can mean that profitable airlines quickly fall into the red and begins to burn their cash reserves.

Because of this many airlines tend to hedge their requirements for turbine fuel ensuring that these hiccups don’t lead to a major blow.

Singapore airlines are currently hedged at $78/barrel on 80% of their total oil consumption till 2025 and with the current market price at $33.25/barrel, the airline is paying more than double the market price. Though, Chinese and Indian airlines do not use the same pricing model.

It's interesting to know that airline companies often sign a forward purchase agreement that helps them fix the prices a few years in advance especially at this juncture when the crude oil prices are trading at low prices.

What does it mean for an Indian consumer?

India imports oil from the OPEC block, and lower prices in global markets should bring down the domestic oil prices. This doesn’t seem to be the case as the Indian rupee is trading weaker against the dollar, and since bills are paid in dollars, the dollar-rupee difference may offset the gains from the lower oil prices.

The most saleable oils in India are petrol, diesel and kerosene and all of these are refined oils. This means that we need to pay an additional fee for processing and transportation and apart from this taxes are added to the retail cost. Therefore the dream that you will be paid to refuel your car will always stay a myth.

Current Crude Dynamics

India is the third-largest buyer of crude and currently has an existing storage capacity of 5.3 million tonnes at Visakhapatnam, Mangaluru and Padur, which is operational and has the capability of holding up 9.5 days of net imports of crude oil. It is going to be a storage war more than a price war that will play out so for India to capitalise on the current scenario the Indian Strategic Petroleum Reserves (ISPR) has approved the building of 6.5 million tonnes of crude oil reserves, which corresponds to 12 days of net crude import, however, it is undergoing long delays as you may expect.

The current momentum in oil prices remains bearish as the fears of economic slowdown and corona virus have come as a double whammy and have caused major disruption in the Indian economy. You might have observed that the petrol and diesel prices are not affected significantly even after the crude oil prices fall, We have explained one of the reasons above in the article but the second reason is that whenever there is a fall in crude oil prices and the economy is slowing down due to various reasons the government doesn’t shy away to take this opportunity and hike the excise duty. Now, excise duty is a form of indirect tax that is levied by the central government for the production, sale or license of certain goods. Excise duties are also collected by state governments for alcohol and narcotics.

As of 1st June 2020, Oil prices have touched a one and a half month high amid signs that demand for crude was picking up with the WTI at $33.25 a barrel at 12:00 am (IST), its highest since the April burnout and the Brent at $34.96/barrel, its highest since mid-April. Both the contracts are on track for a fourth consecutive week of gains. This may seem like a minor miracle given that the WTI price is more than $60 above from where it was about a month ago. So all the jokes surrounding the low crude prices have disappeared.

BB Energy, a London based energy trading house, jumped upon this dip in oil prices on the 20th of April and bought 250,000 barrels of oil and has likely made a fortune now! The sudden rise in prices is because many countries are slowly opening up and the demand is picking, though the economists warn that this rise may be temporary. You ask why? It’s temporary because the world is anticipating a second wave of corona virus and therefore the July and August contracts’ prices may be gloomy.

Remember that just as fortune-tellers couldn’t predict COVID-19 a year ago, you can't expect today’s oil traders to make accurate predictions about the oil prices beyond the short term.

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