From UPSC perspective, the following things are important :
Prelims level : West Texas Intermediate (WTI), Brent Crude
Mains level : Global crude oil pricing dynamics and its impact on India
- Recently US oil markets created history when prices of West Texas Intermediate (WTI), the best quality of crude oil in the world, fell to “minus” $40.32 a barrel in New York.
- Not only is this the lowest crude oil price ever known the previous lowest was immediately after World War II — but also well below the zero-mark.
- At this price, the seller would be paying the buyer of crude oil $40 for each barrel that is bought.
Crude oil price dynamics are undergoing dramatic changes this year. The ongoing pandemic has worsened the situation further. India has ample opportunities to get benefited from the ongoing situation.
But how can that be? How did prices fall below zero in the first place? Let us see:
Global fall in crude oil prices
- The first thing to understand is that, even before the Covid-19 induced global lockdown, crude oil prices had been falling over the past few months.
- The reason was straightforward. The price of a commodity falls when supply is more than demand.
- The global oil pricing is by no stretch an example of a well-functioning competitive market. In fact, it’s seamless operations crucially depend on oil exporters acting in consort.
OPEC+ failure (earlier)
- Historically, the OPEC, lead by Saudi Arabia, which is the largest exporter of crude oil in the world (single-handedly exporting 10% of the global demand), used to work as a cartel and fix prices in a favourable band.
- It could bring down prices by increasing oil production and raise prices by cutting production.
- In the recent past, the OPEC has been working with Russia, as OPEC+, to fix the global prices and supply.
- This happy accord came to an end as Saudi Arabia and Russia disagreed over the production cuts required to keep prices stable.
- As a result, OPEC undercutting each other on price while continuing to produce the same quantities of oil.
What it costs to a country for cutting production
- The production cut was made worse with the growing spread of Coronavirus, which, in turn, was sharply reducing economic activity and the demand for oil.
- It must be understood that cutting production or completely shutting down an oil well is a difficult decision because restarting it is both costly and cumbersome.
- Moreover, if one country cuts production, it risks losing market share if others do not follow suit.
Demand-supply mismatch got worse
- By the time the Saudi Arabia and Russia discord was sorted out last week, under pressure from US President, it was possibly too late.
- Oil-exporting countries decided to cut production by 6 million barrels a day — the highest production cuts — and yet the demand for oil was shrinking by 9 to 10 million barrels a day.
- This meant that the supply-demand mismatch continued to worsen right through March and April.
- According to reports, all possible the mismatch resulted in almost all storage capacity being exhausted.
What led to negative oil prices: Immediate causes
- The contracts fir this month for WTI, the American crude oil variant, was due to expire. As the deadline came near, prices started plummeting. This was for two broad reasons.
- There were many oil producers who wanted to get rid of their oil even at unbelievably low prices instead of choosing the other option shutting production.
- The space to store the oil too got exhausted. Trains and ships, which were typically used to transport oil, too, were used up just for storing oil.
- They figured that it would be more costly for them to accept the oil delivery, pay for its transportation and then pay for storing it, especially when there is no storage available than to simply take a hit on the contract price.
- It is important to note that it was the WTI price for May in the US markets that went so low.
- Crude Oil prices elsewhere fell but by not so much. Moreover, at least for now, oil prices are pegged at around $20 a barrel.
- It is likely that this was a one-off event and will not happen as producers are forced to cut back production further.
- But one cannot rule out such a repeat, with COVID-19 continuing to spread, demand is falling every day.
- In the end, it would be the demand-supply mismatch (adjusted for how much can be stored away) that will decide the fate of oil prices.