Getting Paid To Buy Oil: Can You Believe this?

"Whoever controls oil, controls much more than oil."

Oil is one commodity whose importance can not be stated enough, be it economic, strategic or geopolitical. Like blood is vital for a human body’s survival, oil is vital for a country to function and operate sm oothly. Countries have even waged war for control over oil.

But if oil is so valuable, how come it commanded a negative price, and traders offered to pay people to buy oil?

To understand this, we need to go back in time and understand positions and interests of the biggest oil producing and consuming nations, take a look at how oil is priced and traded, and put it all in perspective given the current pandemic situation worldwide.

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In the oil industry-speak, there are two kinds of countries, net producers, which, sitting on top of gargantuan oil fields, produce more oil than they consume, and net consumers, which consume or import more oil than they produce.

Until the mid-1900s, the industry was majorly controlled by the U.S. It was the biggest producer and at the same time, the biggest consumer of oil. This predominant control resulted into the market being a buyer’s market. The US was always able to exercise influence over prices. Next most significant oil producers, Saudi Arabia and Venezuela found this perpetual bullying frustrating.

The formation of the OPEC, proudly called a cartel, changed the dynamics of the international oil market once and for all, converting a consumers' market to a suppliers' market.

In 1960, they decided to come together in a group, which they proudly address as a cartel and formed what we know today as the OPEC, the Oil Producing and Exporting Countries. OPEC was a consortium of significant oil producers and exporters outside of the U.S. majorly comprising nations in the Middle East and Africa. A newly established power in the market had now changed it to a seller’s market for once and for all.

The dynamics of oil prices has been affected by a multitude of events since. Recession periods, wars, geopolitical tensions and constant attempts at exploitation have all been a part of this greasy journey. In the recent past however, two significant events have played a major role in redistributing power in the oil industry.

The US discovery of fracking methods to extract oil from shale allowed the US to dominate markets once again, after a long time, and that did not go well with the nations who lost their market share as a result.

The first was the U.S. discovering methods of drilling for oil in shale during 2010-2015. Of what we need to know, shale is a rich source of Petrol and Natural Gas and America has large amounts of it stored in its land. To gain perspective on its importance, production of oil with the help of shale, has helped America become a net exporter/producer from a consumer. It is to be noted, however, that drilling earth, also known as fracking, to extract Shale is an environmentally harmful process and has met significant opposition. The silver lining here is that the US government has currently not provided fracking contracts for populated areas.

The second such moment came with the OPEC joining hands with more countries, including Russia, in 2016. Among the new members, the most significant was Russia. This new group, which came to be known as the OPEC+, has been responsible for cutting down oil production to stabilize prices giving in to a constantly decreasing demand.

It is evident how US raced ahead to produce and sell more oil than Saudi Arabia and and Russia and wrested market share in the past decade, riding high on its new-found ability of extracting oil form shale.

Now the expansion of the cartel, while definitely beneficial for furthering the agenda of the member nations, could also be rendered unfruitful in situations when one or more member nations do not agree to production cuts to keep prices above a certain floor price, or when competitor states of the cartel increase their own production to take advantage of cuts at the cartel’s end.

This would inevitably hurt nations who agreed to and acted upon the production cuts since they ended up cutting production, selling lower-than-normal quantities of oil at lower-than-normal prices, and losing market share to non-member nations.

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This brings us to finally address the question of how in the world can oil be traded at negative prices.

As we know, oil prices are directly influenced by the supply and demand in the market at any point of time. Now, it is intuitive that prices will go up if there is a disproportionate increase in demand and prices will go down in there is a disproportionate increase in supply. So, this must have been the reason behind the recent nosedive, right? But the right question to ask here would be, what caused such a disproportionate increase in supply? A few things should be taken note of here.

Oil was traded for negative prices only for the WTI Index and only for the May 2020 series.

This brings us to two questions, what is WTI Index and what is May series?

Benchmarking of Oil

Simply put, oil is drilled for in different geographies and geologies, and that results in variance in quality of oil, measured on multiple factors. Not only this, oil dug up from the sea is easier to ship than oil dug up on land. Both these factors combined influence the final price of oil, and different ratings on these combinations are marked as benchmarks. For example, Brent Crude, used as reference for almost two-thirds of global oil contracts, comes from the North Sea, the West Texas Intermediate (WTI) comes from US oil wells and the Dubai/Oman serves as the main reference for Persian Gulf oil delivered to the Asian markets.

Futures Trading of Oil

Oil can be traded for either in the spot market or the futures market. Trading in the spot market means buying oil at the current price and accepting delivery a few weeks later. As refiners and governments realized during the Oil Crisis of the 1970s, this exposed them to sudden increases in oil prices. The solution came in the form of crude oil futures, which are tied to a specific benchmark crude.

With futures, buyers can lock in the price of a commodity several months, or even years, in advance.

Accordingly, May 2020 series refers to all futures contracts that promise delivery of oil in May 2020. If the price of the reference crude rises significantly, the purchaser is better off with the futures contract. This also proves a beneficial arrangement for investors and speculators, who buy futures contracts when they foresee an rise in spot prices in future. They aim to sell the contract itself at a premium, which enables the buyer of the contract to obtain oil at a price lesser than the increased spot price. This results in a win-win for all.

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Putting the puzzle together

Ever since the formation of OPEC+, all production cuts agreed to have had little effect. Since most of these production cuts were compensated by US shale producers, not only did the prices not go up as intended, Russia and OPEC+ members even lost market share to the US. This led to long bouts of resentment and finally a price war between Russia and Saudi Arabia. Now, since no one wants to lose market share to competitors selling high quantities at low prices, this sparks a prolonged period of production ramped up to insane levels at all major oil producing nations, including the US.

The constantly falling oil prices in the run up to the big crash.

Fast forward a month of such high production, producers are starting to run out of storage capacity. Couple this with lockdowns and stalling of public life and economies across the world due to Covid-19, which means that the demand for finished products at end-consumer level drop by precarious percentages. Consequently, no refiners want to buy crude as well.

As a result, producers don’t have storage capacity to store oil. Refiners won’t buy oil because consumers don’t need fuel. Who is left with a legal obligation to accept deliveries of oil from producers? Futures traders, who signed Futures contracts for oil deliveries in May.

Since investors and speculators expected prices to go up due to production cuts and other factors, they bought these Futures contracts. However, no one could foresee the current pandemic and the subsequent dying down of demand.

Since their business model never included accepting physical deliveries of oil, they did not have any storage facilities. Renting storage space was no longer feasible, and no one wanted to buy oil off them. Hence, the prices crashed.

As the last date to sell the contracts approached, they started accepting losses, and even offered to pay anyone to buy oil off them, since incurring those losses would anyway be cheaper than having to accept deliveries and store oil, or not accepting the deliveries and being dragged to court.

While here we talked about global oil dynamics, we'll be back with more, focussing on oil from a trade strategy and policy perspective in India.