The oil price drop and how we got there

Last week, the May future contract of crude oil prices dropped below zero for a first time in history. US West Texas Intermediate (WTI) crude oil for May delivery traded as low as -$40 a barrel as sellers paid to have oil contracts off their hands. Ricardo Evangelista points out in his article on LinkedIn how surreal and counterintuitive the situation was to have “the black gold” from 65USD per barrel in the beginning of the year to a negative price.

The reasons behind the significant shift in the market is a complex one. Global oil production had grown in the last decade to meet the increasing demands, particularly in China. The demand made more expansive extraction methods such as shale and tar sands, economically feasible. This led United States to become self-sufficient and eventually the world’s leading oil producer. To deal with the market saturation, as prices fell, exporters like Saudi Arabia and Russia increased their input to price-out competitors by making the more expensive extraction processes unappealing.

The oil production kept growing faster than the demand when the storage facilities were already close to full in the beginning of the year. Then in January, the coronavirus outbreak happened in China and the country imposed a drastic lock-down to contain it. As people were not allowed to go out and business were forced to close down, the abrupt drop in demand caused the price to fall more than 15%. In the next couple of months, the coronavirus spread to a global pandemic and many other countries were forced to impose similar measures, bringing their economies to a halt. This caused an extraordinary decline in demand for oil and its derivatives, while the leading exporters failed to agree on adequate decrease in daily production, which is how we ended up with more oil available than could be used or even stored. The global decline in demand is overwhelming at estimated 30 million barrels per day, while the daily production was reduced by only 10 million, meaning there is extra 20 million barrels of oil per day that need new storage.

What happened to oil prices?

This caused the price for the future contract of crude oil, with delivery in May, to drop to negative values. Many traders were obligated to receive a product with no way to sell or store it, so they came down to paying $40 per barrel to anyone who would accept to take their product.

Trading systems’ inability to take negative values represents a potentially huge loss for clients. Yesterday, IS Prime launched new UK & US Oil Index to mitigate that risk. The Prime of Prime and Liquidity Provider developed new US Oil Index and the UK Oil Index to combat the huge risk of spot oil prices falling to negative values again. The Indices are rebased at $100, meaning that in case of IS Prime’s proprietary spot price fall into negative value, e.g. $-5, the pricing will reflect this at $95, effectively preventing stop outs while reflecting the market moves the full underlying volatility of Oil.

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