Since the outbreak of the coronavirus in January this year, there have been numerous economic events which have been simply unprecedented in their nature.
The latest of these, in the wacky world of Covid-19, is oil prices in the US falling to below zero for the first time in history. Yes, that’s right… below zero! What that essentially means is that oil traders who would usually be selling to buyers, are having to pay them to take the oil off their hands instead. At one point on Monday, a barrel of oil was trading at a low of -$37.64.
The major cause of this mind-boggling situation is the extraordinary collapse in the global demand for oil. With countries all over the world imposing lockdowns and halting almost all business and industrial activity, the result has been a huge surplus of oil, with the main concern being the lack of space to physically store it.
In order to fully understand why the price of oil in the US is able to reach a negative value, we must first consider how the market for oil actually works. So here we go…
West Texas Intermediate (WTI), which is the type of oil in question, is traded by investors at its future value. This means that an investor today will agree to buy a specific amount of oil at a future date at a price which is agreed-upon today. In this case, traders in recent months have been buying and selling oil with the actual transaction due to take place in May. The trading contract has a deadline the month before and for WTI purchased in May that deadline is today.
With the demand for oil at an all-time low, oil traders are worried that they will be unable to find buyers in May for the vast quantities of oil that they have purchased on the market. This is an entirely unheard-of situation, with the demand for oil usually so high. With no buyers, oil traders will be forced to store the product themselves as they have to complete the transaction and receive the oil delivery.
Given the limited capacity for storage, the costs which would then be incurred by the oil traders would result in significant losses. To the extent where giving the oil away for free, which in this case didn’t even work, or paying buyers to take the oil makes more financial sense and would lead to a reduction in losses.
This story is yet another example of how the outbreak of Covid-19 has shattered the global economy, throwing us all into a world of complete and utter economic uncertainty. It is likely that the price for WTI will rise above zero as the market for future months corrects itself, but with global demand continuing to plummet, it will remain low and oil producers will be trying desperately to reduce output.
THINK LIKE AN ECONOMIST!
Q1. Explain why the demand for oil is so low.
Q2. Why are oil traders having to pay buyers to take oil off their hands?
Q3. What is a ‘future value’?
Q4. Discuss why this is described as an ‘unprecedented economic event’.
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