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Too low for zero

21 April 2020 By George Hay

Oil has entered a new world. After the shock of seeing the cost of a barrel of U.S. crude for delivery in May drop far below zero on Monday, the question is whether energy prices will rebound to the $20-$30 band in which they have been trading recently or whether investors will be permanently scarred. Logic, and market moves on Tuesday, suggest the latter.

As of 1320 GMT the front-month contract for West Texas Intermediate, which expires today, had recovered to minus $5 a barrel, from the dizzying depths of Monday’s minus $37 a barrel. But WTI oil for delivery in June has lost over a fifth of its value and is trading at $15 a barrel. More striking still, Brent crude for the same month’s delivery has fallen by the same amount, to below $20 a barrel.

The drop in the WTI June contract is logical. The reason oil investors were on Monday literally paying buyers to take expiring oil contracts off their hands is because they have nowhere to store it, as they have to take physical delivery of it in Cushing, Oklahoma and all storage facilities are either full or booked. Given a 20%-30% coronavirus-led collapse in global demand is causing storage to fill up rapidly, the same could happen in the next month.

There are more barriers to Brent turning negative. Unlike WTI, it can be settled in cash instead of having to be physically delivered. There’s also scope to put excess Brent supply in floating tankers, which makes the storage crunch less extreme. More importantly, the 9.7 million barrels of daily supply due to be cut from the market from next month by Saudi Arabia, Russia and allies is mostly priced in Brent.

Prices don’t have to fall below zero even if there is too much supply and too little demand. If energy production cuts are insufficient and global storage is exhausted, near-term oil prices need to drop to around $10 a barrel, a level at which many oil producers can’t cover even their production costs, one trader told Breakingviews.

That, however, is where Monday’s trauma kicks in. Now that the negative-price genie is out of the bottle, Brent could follow WTI if the latter’s June contract drops below zero. Market overshoots can occur when prices are falling just as easily as when they are rising.


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