Why Did Crude Oil Prices Drop Below Zero?
During the height of the 2020 coronavirus pandemic, global demand for crude oil plummeted drastically due to lockdowns and travel restrictions. Little did industry players anticipate this sudden and significant drop in demand, while supply remains relatively sticky. In other words, once production begins, it is hard to stop, often resulting in permanent damage to production facilities if halted abruptly.
US Storage Capacity and International Transportation
Amidst this reduction in demand, the United States found itself bracing for a crisis. Storage facilities filled rapidly, and even surpassed capacity. Consequently, tankers that typically transport crude oil were repurposed as makeshift storage units, unable to transport oil to other markets with storage capacity to spare.
The Looming Crisis
Crude oil, being a hazardous material, cannot be simply discarded. This necessitated sellers to offer oil at negative prices, essentially paying buyers to take the fuel off their hands and find suitable storage. This situation transformed a profit-making activity into a disposal fee affair.
Understanding Commodity Futures and Spot Markets
To tackle this issue, we need a basic understanding of how commodity trading works. Commodities like crude oil can be traded in two ways: the spot market and the futures market. A spot market transaction is a straightforward exchange, like buying a cup of coffee 'on-the-spot' at a coffee shop. In contrast, futures trading involves agreements to buy or sell goods at a predetermined price, with delivery at a future date. This is common in the energy sector, where prices are set not for immediate delivery but for future months.
The most significant oil price that garnered international attention was the May 2020 WTI contract offered by the New York Mercantile Exchange (NYMEX). On the last trading day of the contract, May 20, the oil price fell to a record low of -$37.63 per barrel. This negative price reflected the inability to store excess oil, suffocating supply over capacity constraints.
The Role of Delivery Date: Contracts and Storage
Contracts in the futures market are specific to delivery dates. For instance, the May 2020 contract determined the price for delivery by the first week of June, as of the current date. On the expiry day, if a receiver was unable to store the incoming oil due to lack of storage, the buyer could ask the seller to keep the oil for a storage fee. This agreement often led to a situation where the seller effectively paid for storage to prevent the oil from reverting to negative pricing.
Conclusion
The drop in crude oil prices to negative territory was not just a response to a temporary market imbalance but a symptom of broader supply and storage challenges. While historically unprecedented, the concept of negative pricing underscores the complexities of the global energy landscape in times of crisis. Understanding these dynamics is crucial for businesses and investors navigating the volatile world of oil trading.