Patterns governing the oil market
No one needs to be convinced how difficult it is to predict oil price changes, although the reason is not ignorance of the oil and fuel price drivers, but the emergence of unforeseeable events affecting the relationship between demand and supply. As regional oil/fuel markets and economies are globally intertwined, what we are dealing with here is the butterfly effect. The symbolic undercooked bat from the Wuhan market got oil traders from Cushing, US, to pay through the nose to get rid of their stocks on April 20th 2020. A lot of publications have since come out offering a shortcut explanation of patterns governing this specific market. However the devil is in the detail, which is worth finding out.
WTI and Brent are priced differently in spot transactions
A spot price is the price on the physical market with short delivery times. In other words, it is the price of a transaction executed at a specific place and time when the oil changes hands, under standard trading conditions.
‘On the spot’ means ‘at the particular place’ where the price is quoted. For WTI, the spot is Cushing, Oklahoma, where physical transactions involving on-the-spot sale/collection still take place (both the seller and the buyer must have storage space available).
For Brent, the spot, i.e. the place of trade, is the North Sea, as crude oil is loaded on vessels on a continuous basis and the cargoes often change hands. Spot prices are assessed by agencies such as Platts and Argus, based on a wide range of information from both physical and paper markets (which I will discuss later on). What Platts assess is the spot price of crude oil called Dated Brent. It is a benchmark assessment of the physical price of light crude from the North Sea, from a basket of five crudes (Brent, Forties, Oseberg, Ekofisk and Troll). The term ‘Dated Brent’ refers to physical crude cargoes in the North Sea assigned specific delivery dates. Every dated crude cargo, before being processed by a refinery, is often purchased and sold more than once. Platts’ analysis of trading activity culminates in the publication of their Dated Brent quotation – a daily assessment of the price of Dated Brent on the North Sea crude oil market.
Until recently, spot prices and prices under front month futures were virtually the same. How come they now vary so widely?
Usually, spot prices and commodity exchange prices under front month futures are very close but not identical. The differences are sometimes more pronounced, especially during strong turmoil on the oil markets, because the physical and paper markets’ response times vary. Typically, the reason lies in diverging assessments of the storage costs (expected at the time when the contract is written and the delivery is made). The slope of the forward curve is also critically significant. As the slope increases (or as the curve steepens, as this is described in jargon), so does the difference between the spot and futures prices. This is the case when significant oversupply emerges on the spot market, which needs to be quickly stored. It is the forward curve steepening, achieved following a sharp enough drop in spot prices, that encourages building up stocks. WTI is more exposed to differences between spot and futures prices as there is a single physical place of price quotations (Cushing) and the need to physically collect the oil after a contract matures, which involves additional storage costs, especially for traders not prepared for such eventuality.
Brent crude, on the other hand, does not have to be physically delivered, but contracts may be cash-settled.
On April 21st, the price of WTI crude on the physical market fell below zero. How did this happen?
Financial dealers are not prepared to collect physical barrels of oil, so they avoid taking positions on the physical market by selling forward contracts to physical dealers prior to contract maturity dates. Not all of them were successful. Those left with no choice but to physically collect the oil in May would have to bear additional storage costs, the amount of which could only be guessed at with no willing buyers (the ownership of oil is transferred while it is being stored). The option they chose was to sell it at a known cost, that is at the negative price, paying the buyers just for taking it off their hands.
What is trading in crude oil futures about?
Oil futures provide liquidity on the physical market. Futures allow the oil market to readily absorb any surplus (as the structure of prices for different delivery dates encourages storage) and get rid of it. The possibility of hedging against oil price changes supports the profitability of both upstream operations and fuel production. Contracts are written by clearing chambers. A sale contract is a financial product covering a standardised volume of crude oil, its price being determined by the market. A buyer purchases the contract at the market price and undertakes to collect a specific volume of crude oil at a specified time. Before the contract matures, this undertaking is an option, which can be disposed of by selling the contract. When the contract matures, this option expires and the contract owner is required to take the physical delivery of crude oil, which will be made in the first (second, third) month after the contract expiry date.
How susceptible is oil to speculation? Can its market price be at variance with the real value?
Oil futures trading is referred to as speculation in the economic lingo. Crude oil price is susceptible to speculation because any piece of information that may affect/change the demand and supply and, ultimately, the price of crude oil is factored by financial dealers into contract prices.
What matters is a time window through which one views the crude oil market and price. Financial dealers and physical traders monitor the markets on an ongoing basis, swiftly reacting to any new piece of information, while oil and fuel producers (the upstream industry and refineries) view crude oil prices through monthly, quarterly and annual windows, where prices are less susceptible to change and depend to a greater extent on fundamental factors such as real demand, production or changes in stock levels. We only learn about actual changes in these factors (GDP, changes in global stock levels) with a time lag, sometimes of several months.
Research shows that speculation merely reinforces the oil price movements resulting from fundamental factors. In other words, speculators do not change trends following from fundamentals such as production volumes, production costs, consumption volumes, stock levels, etc.
The market price of crude oil fluctuates around its real value, going up and down every day, but averaging at a level that would ensure long-term profitability of production matching future demand. If the price is too low, there is a supply shortage that sends the price soaring (as it did in 2005–2010). If it is too high, new technologies emerge to ramp up production, pushing the market into oversupply, and the price plunges (as it did from mid-2014 to 2017).