Throughout April and May of 2020, news headlines have echoed concerns regarding an unprecedented phenomenon; negative oil prices.
Now, before we delve into this counterintuitive concept, it is imperative that we make a clear distinction that the media tends to not place emphasis on. Oil future contracts were traded negative only for the month of May.
Two definitions will help you navigate some of the more complex terms in media articles that cover commodity trading:
“Spot prices” refer to the current trading price within the marketplace that can be bought and sold immediately.
“Futures” refer to contracts that determine the price to be paid on barrels that will be delivered in the future (coming months).
As the deadline for May deliveries approached, supply of oil far exceeded demand for oil in the global economy. Although there are a myriad of other factors at play, two primary events have been regarded as the root cause of oil prices plummeting to a low of almost -$40 per barrel in late April.
The pandemic lockdowns have significantly reduced demand for oil throughout the world, leaving an excess average of 26 million barrels per day which would have, under pre-pandemic conditions been consumed.
“With oil crashing into negative territory, it’s becoming clear the world’s thirst for crude has dried up” – Bloomberg “Oil Prices Drop Below Zero for First Time” Video
Due to this decrease in demand, oil producers were forced to fill storage facilities with excess barrels of oil. These facilities have moved towards their capacity, forcing producers to resort to paying buyers to take these barrels out of their hands, in order to alleviate pressure on their storage limits.
The rationale of paying others to take oil resided in the idea that it would be more expensive to close down oil production at capital intensive infrastructure locations.
In March, the Organisation of the Petroleum Exporting Countries (OPEC) proposed that members and partners (commonly regarded as OPEC+ countries) decreased their oil production to offset price reductions that decreases in demand for oil due to COVID-19 would cause. However, Russia walked away from this proposal and instead increased production of oil, putting downward pressure on the price of oil and in turn, increasing their sales through discounted offerings.
Saudi Arabia also joined this strategy (divergence from OPEC proposals) and in doing so created the oil price war, a battle for market share in the oil market.
“flooding the market is what caused us to go to a very low level. And then the pandemic basically took it almost to a very dangerous area… negative pricing” Saad Al-Kaabi, Qatar’s Minister for Energy Affairs and CEO of QatarPetroleum
Negative oil prices have been regarded as a strong reflection and omen of decreases in gross world product (GWP). GWP refers to an increase in the production of goods and services over a period of time amongst all economies within the global economy.Hence, plummeting prices of a commodity that is nought and sold in the global marketplace, suggests that GWP will fall drastically as a result of COVID-19.
As indicated above, for a price to plummet to the extent that as oil has (large fall on the y-axis), demand would have also had to decrease by a significant amount.
Negative oil prices have elevated feelings of uncertainty plaguing investor confidence and sentiment during this pandemic. It can be argued that this “omen” has contributed to increased volatility in global financial markets and “spooked” investors. An important point here is that sentiment tends to align with herd mentality, that is the idea that confidence or its polarised emotion in the financial landscape, uncertainty, is contagious amongst global investors and delicately contingent upon geopolitical and headline events.
Despite being an omen, businesses that were still in operation during May and in demand for oil reaped cost side rewards from low oil prices. Crude oil represents an intermediate good, that is that they are utilised within the production process to create parts of a finished product. Thus, the reduction of a key input of production alleviates cost pressures within supply chains, effectively reducing the price that producers are willing to set to consumers.
As indicated above, reducing the price of an input of production will increase production levels and in turn decrease prices via a reduction in cost push inflation.