The Free Fall of Oil Prices: Oil Economics- Of Brent, WTI and OPEC plus Explained for UPSC Exam
(Read full article to understand how oil futures & contracts work, their impact on Oil prices)
What is happening?
For the first time ever, a key U.S. oil benchmark, West Texas Intermediate, went below zero on 20th April, as Oil traders (future contracts) approach a deadline to find buyers.
The entry of prices into negative territory meant that the sellers (of oil or its contracts) will pay money to get rid of the oil stock they have.
Why is this happening?
This unprecedented shift comes as the global oil markets continue to grapple with a pandemic-driven collapse in demand. At the start of 2020, a barrel of WTI cost around $60. Prices had dropped swiftly because of the coronavirus, landing at around $18 a barrel.
Then on 20th April, they plummeted through the floor. WTI for May delivery settled at a negative $37.63 — meaning traders are paying $37.63 to get someone to accept a delivery of a barrel of oil.
The plunging price of WTI was driven by a trading contract deadline to oil traders to sell off the current futures contract. And they needed buyers that are capable of receiving and storing that much oil. And, those buyers are in short supply.
Are all Crudes falling?
Other types of crude, without a deadline, have not dropped nearly so sharply. In general, however, crude oil prices are very low and continue to fall. Brent, an international benchmark, is in the mid-$20s.
Why are all the Oil Prices suffering?
Oil-producing countries and companies are trying to reduce their output, but they can’t keep pace with the extremely rapid drop in global demand as the world economy hits the brakes. That’s creating a massive oversupply of oil and raising concerns about where buyers will be able to physically store it all.
Difference between Brent Crude and West Texas Intermediate (WTI)
The Organization of the Petroleum Exporting Countries (OPEC) controls most of the oil production and distribution, often dictating costs for not only oil suppliers but countries as well. Most nations factor oil prices into their budgets, so OPEC has been considered a leading geopolitical force.
- Both Brent Crude and West Texas Intermediate (WTI) are light and sweet, making them ideal for refining into gasoline. But WTI is also slightly “sweeter” and “lighter” than Brent.
- West Texas Intermediate (WTI) is slightly lower in price than Brent, despite the transportation cost being higher. This is because of the American Shale Revolution since 2000s in North America and Technological progress in drilling and fracking, alongside cheaper loans to Investors in the Oil Business.
- In fact, the increased production led oil prices to fall from above $100 to below $50 from 2014 to 2015
- With a surge of WTI production, many traders have come to consider it an important pricing benchmark vs. Brent, if not even close to the total production of the latter.
- Brent Prices are more uncertain than WTI because of the geopolitical factors. Middle-East is more prone to political crises than the North America
Brent Crude and West Texas Intermediate dominate the oil market, and both dictate pricing in their respective markets.
Why do the Oil Prices go up and down? Can’t they remain constant?
Crude oil is a “commodity”, just like corn, coffee beans and raw materials like gold and copper. The prices of commodities are always in flux because they depend on worldwide supply and demand.
For Eg: When ethanol fuel started becoming a popular alternative fuel option in vehicles, the price of corn — from which ethanol can be produced — spiked. Also, if an Oil refinery explodes, the supply gets compromised causing the price of oil to increase.
It’s not just Demand and Supply, there’s more to the story of Crude Oil prices
Four major factors help determine the price of oil: Supply & consumption, government policies, Geopolitics and financial markets
- Supply and Consumption
Basic economics teaches us that a high supply of oil means demand (consumption) is not enough or low, which means that the prices will be low, and vice-versa
- Government regulation
Recently passed rules on sulfur content could raise the demand for sweet crude oil — a type of crude oil with less sulfur — but sweet crude oil is less common than other types of oil. And laws aimed at preventing climate change will likely raise the price of energy, too. Taxes on petroleum products by nations can also affect consumption pattern and consequently, the prices.
The governments continue to find ways for people to switch to power sources like wind and solar energy — and drive more fuel efficient cars — so it’s possible that the demand for oil will go down, simply because we won’t need it as much anymore.
- Geo-Politics (OPEC and OPEC plus Explained below)
OPEC countries, led by Saudi Arabia, did not want to lose their market share to Russia even as the oil prices started to plummet. The OPEC plus, which includes those countries which export Oil, failed to reach an agreement in March, 2020 on production cuts to arrest the falling prices in the wake of COVID-19 pandemic.
One can imagine this: If the selling price is at such low levels, how can the businesses run even as they incur the same cost of production
In April 2020 (9th April), an agreement was reached by OPEC plus to cut production starting May. This sudden turnaround in a month was due to USA nudging its ally, Saudi Arabia, to reach an agreement. Why did the USA give a push now? The Oil demand across the world has come to a standstill, and the US refiners will be forced to cut prices to retain their market share. The US Oil refining companies are already under severe stress, unable to pay up the loans they had borrowed to install new technologies and capacities.
Russia was ready to take production cuts earlier too, for its economy hinges on Oil revenues.
- Financial Markets
Similar to the stock market, which involves trading investments in various companies, people also trade in commodities at financial markets.
People purchase “futures” — a sort of bet on whether a commodity will increase in price at a later date. Once locked into a futures contract, the buyer will get his or her commodity at that price and that date, regardless of whether the market price has changed or not. These futures are traded in Commodity markets like
- the New York Mercantile Exchange (or NYMEX), as well as the International Petroleum Exchange.
- In India, we have MCX (Multi Commodity Exchange of India) and ICEX Indian Commodity Exchange)
The way oil is traded on the financial market has a massive influence on its price. Speculators invest in oil futures (or contracts), essentially betting on how much oil will cost at a later date, and this in turn affects how other people think oil should be priced. It also affects how much oil the petroleum companies will release to the market.
Speculators can swing the prices
Commodity futures have a surprising effect on crude oil prices — speculators who buy large amounts of futures can swing the price one way or another.
Here’s an example: A speculator who buys oil futures at higher than the current market price can cause oil producers to horde their oil supply so they can sell it later at the new, higher “future” price. This cuts the current supply of oil on the market and drives up both present and future prices.
While it may seem unfair that speculators have so much sway over the oil market, keep in mind that speculation is a part of any financial system, and stock investments are an act of speculation in and of itself. When you buy stock, you’re speculating on a company’s future
So, are we going to get paid to fill up at petrol pumps?
No, we will not get paid for filling the petrol/diesel at pumps because:
1. there are costs to operate refineries
2. Taxes on petroleum products
3. It’s only the WTI futures market prices which are in negative, that too for May contracts. Brent Crude futures are still trading positive (fears are that they might as well slip to zero)
4. The Spot Market prices are still in positive.
Who benefits from the Oil prices nosedive? And Will India benefit from this? Yes
All net importing countries will benefit from it. China being the largest petroleum importer, benefits the most. In fact China is building up its strategic reserves. India too will benefit a great deal from the decline:
1. Import bill falls, thus Current Account Deficit (CAD) falls
2. Fiscal Deficit of the govt falls, if the govt decides not to pass on the price decline to consumers. It may consolidate its revenues by increasing the taxes by letting the prices be, as they stand today
3. India is shoring up its Strategic Petroleum Reserves at Mangalore, Vishakapatnam (Vizag) and Padur
It’s a paradoxical situation —— even if the govt passes on the benefits to the consumer, the demand just cannot pickup and translate to actual benefits because of the lock-down and low economic activity overall