DERIVATIVES & RISK MANAGEMENT

Prof. Prabhat Varma

ASSIGNMENT 1
CASE STUDY REPORT

On

Negative Price of Oil Futures

Submitted by:
Mr. Abhishek Rane 81
Ms. Madhuri Shirkar 40
Mr. Mustafa Shaikh 85
Mr. Nilesh Davare 51
Ms. Pooja Jain 21
Mr. Toraab Shaikh 84
Mr. Tushar Dahiwale 07

Kohinoor Business School, Kurla

S.Y.M.M.S (2019-21)

Dated: 30th July, 2020

Case Study:
A study on Negative Prices of Oil Futures
Oil has become the world's most important source of energy since the mid-1950s. Crude oil
will be an indispensable raw material for years to come - mainly for the chemical industry,
since it's too precious to be consumed for heating or as fuel.

Wars because of Oil

 Chaco War
The Chaco War (1932–1935) was fought between Bolivia and Paraguay over control of the
northern part of the Gran Chaco region of South America, which was thought to be rich
in oil. It was the bloodiest military conflict fought in South America during the 20th
century, between two of its poorest countries.
  Iran–Iraq War
The armed conflict between Iran and Iraq began on 22 September 1980, when Iraq invaded
Iran, and ending on 20 August 1988, when Iran accepted the UN-brokered ceasefire. Iraq
planned to annex the oil-rich Khuzestan Province and the east bank of the Shatt al-Arab.

 Gulf War
The Gulf War (2 August 1990 – 28 February 1991), code named Operation Desert Shield in
defence of Saudi Arabia. Operation Desert Storm in its combat phase, was a war waged
by coalition forces from 35 nations led by the United States against Iraq in response to
Iraq's invasion and annexation of Kuwait  arising from oil pricing and production disputes.

Why oil is quoted in dollars?

In 1971 the then president of US Richard Nixon was forced to close the gold standard
which led to massive devaluation of dollar. To set the things right he negotiated a deal with
SAUDI ARABIA for accepting dollars as standard payment for crude in exchange for arms
and security. This started working for them. America then sensed the importance of crude
in the constantly modernising world and settled with similar deals with other OPEC(oil and
petroleum exporting countries) thus creating a demand for dollar.

Uncovering the oil and gas industry

Considered to be the biggest sector in the world in terms of dollar value, the oil and gas
industry is a global powerhouse employing hundreds of thousands of workers worldwide as
well as generating hundreds of billions of dollars globally each year. These oil and gas
companies are so vital they often contribute a significant amount towards national GDP.

What are the different oil and gas sectors? 

The oil and gas industry can be broken down into three key areas: 
 Upstream, 
 Midstream
 downstream.

What is upstream?
The upstream component is also referred to as the exploration. This involves the search for
underwater and underground natural gas fields or crude oil fields and the drilling of
exploration wells and drilling into established wells to recover oil and gas.

What is midstream? 
Midstream entails the transportation, storage and processing of oil and gas. Once resources
are recovered, it must be transported to a refinery, which is often in a completely different
geographic region compared to the oil and gas reserves. Transportation can include
anything from tanker ships to pipelines and trucking fleets. 

What is downstream?
Downstream refers to the filtering of the raw materials obtained during the upstream phase.
This means refining crude oil and purifying natural gas. The marketing and commercial
distribution of these products to consumers and end users in several forms including natural
gas, diesel, petrol, gasoline, lubricants, kerosene, jet fuel, heating oil, LPG etc.

Trading of Crude?
Crude oil is one of the most actively traded commodities in the world, and its price affects
the price of many other commodities, including gasoline and natural gas. It remains a major
source of energy for the world, despite increased interest in the renewable energy sector.

Type of Crude?
Crude oil with low sulphur content is classified as “sweet.” (WTI) is crude from U.S. wells
and it is light and sweet. Crude oil with a higher sulphur content is classified as “sour.”
Dubai and Oman oil falls into the category of heavy and sour oil. Sulphur content is
considered an undesirable characteristic for both processing and end-product quality. Light
Crude oil's American Petroleum Institute (API) gravity is greater than 10 (the gravity of
water), it is lighter than water and will float on it. (WTI) crude oil has an API gravity of
40.Heavy Crude oil's API gravity is less than 10, it is heavier than water and will sink. .
Alaska Heavy crude oil has an API gravity of 8. Lighter crude is less expensive to produce.

Type of Crude Benchmarks?

West Texas Intermediate (WTI)  is used primarily in the U.S. It is light and sweet thus
making it ideal for producing products like gasoline and diesel.
Brent Crude is a mix of crude oil from 15 different oil fields in the North Sea. It is the
benchmark used primarily in Europe though it is also mixed in with the OPEC reference
basket which is used around the world.
Dubai Crude, also known as Fateh, is a heavy sour crude oil extracted from Dubai.
Canadian Crude are benchmarks crude oils for the Canadian market.

Brent oil has traditionally quoted higher than WTI.

What are futures contracts?

Futures contracts are agreements to buy or sell a particular commodity or an asset at a
future date. When it comes to crude oil futures, contracts are allowed for up to nine years in
the future.

April 20, 2020 will go down in oil-market history as the day when the U.S. benchmark
price for crude dropped below zero for the first time -- and then kept falling. In a massive
and unprecedented swing, the future contracts for May delivery of West Texas Intermediate
tumbled to minus $37.63 a barrel.

In the age of coronavirus and the aftermath of a price war, the world’s most important
commodity is quickly losing all value as chronic oversupply overwhelms the world’s crude
storage capacity.
Where did the glut come from?
As the virus started to spread around the globe, it began eating away at oil demand. Saudi
Arabia and Russia, the world’s biggest oil producers, escalated the price war. A pact that
had restrained production collapsed and both countries opened their taps to the fullest,
releasing record volumes of crude into the market

During week (13 – 18 April), traders put $ 1.6 billion into the United States Oil Fund, the
best week of inflows on record for the exchange-traded fund since its inception in 2006.
OPEC, Russia, the U.S. and the Group of 20 countries call for an overall production cut of
roughly 10% proved to be too little, too late.

Where things gone wrong?

Prices initially turned negative just in the U.S. market such as Wyoming, where storage
options are few. Then major hubs began to register negative prices for small streams of
selected crudes. Contracts for May delivery were due to expire on April 21, putting
maximum pressure the day before on traders whose contracts were coming due. For them,
selling at a steeply negative price was better than taking delivery of actual oil because
nobody needs it and there are fewer and fewer places to put it. The hiring contracts for
VLCC (very large crude carriers) that can store up to 2 million barrels of oil are soaring
through the roof. According to a report in the Wall Street Journal, VLCC hiring charges
were increased to $72,500 a day compared to $30,500 a day a year ago.
Case Solution:

Q.1) what are the factors lead to negative price of crude futures?

Solution:
1. Oversupply & fall in demand
The supply of crude oil has for outweighed demand since the coronavirus pandemic
halted economic activities. But it does not fully
represent the actual oil price. Around 4 months
ago oil prices were rebounded, gains were
capped, however, amid unresolved concerns over
imbalance between supply and demand. Covid 19
has dropped the need for oil to an all-time low
because the flights have been cancelled due to the
lockdown, so the demand of jet fuel dipped. The people are not stepping out of their
homes, so the demand for oil in car tanks also fell. The factories are all lying shut, so
the demand for requirement of crude oil there too has fallen.

2. Overproduction & shortage of storage

As oil storage facilities around the world are
filling up, offshore oil storage has also increased
significantly. In the case of WTI, the oil is
extracted from the land and is transported in
pipelines and bought to Oklahoma, which is the
sole delivery point as compared to Brent Crude,
which has multiple delivery points. Majority of
the oil storage facilities of USA are in Cushing, Oklahoma. Therefore, there is such an
acute shortage of storage for the oil producers there are ready to pay to take away the oil
because they don’t have enough space to store it. They already have produced so much.

3. Future contracts
Oil is traded in futures contracts that specify how much crude the buyer has obtained,
and when it will be delivered. Between the open
and expiry of a contract, typically a period of
around a year, it can be bought and sold. Many
investors buy and sell these oil contracts to make
a profit, without ever seeing a physical barrel – a
profession known as futures trading.
Futures of crude oil going negative meaning that
sellers were paying buyers to take oil from them, rather than the other way around. If
refineries ultimately don’t want oil, it has little to no value.  If you have oil and nowhere
to put it, it can have negative value. Absent a sharp demand return, production will need
to be reduced more rapidly than what’s happening now.
Oil’s nosedive to negative pricing was a result of two key factors.
Coronavirus : has caused an unprecedented drop in demand for petroleum products as
people stay at home rather than driving their cars or working in factories, and airplanes
sit dormant due to restrictions on international travel. Oil prices have never been
negative before. The fact that prices went negative reflects the magnitude of the
problem that the coronavirus pandemic has caused for the global economy. While top
producers have already decided to take measures that will see around 20 percent of
crude supply removed from markets, the slump in prices suggests that even this may not
be enough.

Traders : Who often do not even have a place to put oil and are just trading the
commodity electronically, ended up having to pay to get rid of their futures contracts
because they had nowhere to store it – otherwise known as negative pricing. Negative
prices indicate that traders became so desperate to get rid of the contract that they would
rather pay someone to take it off their hands than try and find a place to put the oil.

4. Russia v/s Saudi Arabia, Oil price war

OPEC was formed in 1960, when some of the
Oil price War world’s major oil exporting nations came
together to manage the supply of oil to set a
standard price on the world market and avoid
massive fluctuations which would affect
economies. Russia & USA were not a part of
OPEC. In 2016, Russia & Saudi Arabia formed
the OPEC+ Alliance. Russia was the biggest non-OPEC player in this alliance and
world’s 3rd largest oil producer after Saudi Arabia. It was suggested to cut oil
production, but Russia did not agree as its concern was giving too much ground to USA,
already the no. 1 oil producer in the world & they also wanted to produce as much oil as
they can. Russia decided to leave the alliance & Saudi Arabia have issued a stern
warning to Russia that it’s a decision they will regret with this price war waging, oil
stability remains very fragile.

5. Russia v/s USA, An oil war

As a matter of fact, around 30 years prior to
An Oil War today, USA had been an oil importing country,
but around 2010-14 there was a revolution in its
oil industries, due to which USA became an oil
exporting country and made USA the world’s
no.1 oil producer. It left Russia & Saudi Arabia
lagging. USA snatched away the market share
from Russia & Saudi Arabia. The supply of oil increased & the oil prices fell. Due to
this the supply of oil increased and the oil prices fell. This meant the profit of the OPEC
 & Russia began to decrease. Then OPEC thought that they would have to destroy the
USA’s oil industry & keep their share market maintained, if they wanted to keep
accruing profits in the future. In order to do this, the OPEC & Russia decided to
increase their production. Here Russia wanted to attack the US industry in the form of
prices and wants to destroy it.

Q.2) How could it be avoided?

Solution:
1. Storage = Production
The coronavirus has emptied out cities around the world. Fewer people are driving cars
or boarding planes. Factories are idled. As a result, the world burning less oil. But many
of the world’s major oil producers have been pumping more than ever, leading to a
crash in oil prices! Oil is piling up with nowhere to go. Pipelines are filling. Refineries
and storage tanks are brimming, and some oil is being stashed at sea on ships. This
situation could be avoided if the production done was according to the storage
capacity.

1. Demand = Supply
If the demand for something is more while the supply is less, then its price will rise &
vice versa. The matter of fact is the demand for oil worldwide has fallen so drastically
in the past 4 months. The flights have been cancelled due to the lockdown, so the
demand of jet fuel dipped. The people are not stepping out of their homes, so the
demand for oil in car tanks also fell. The factories are all lying shut, so the demand for
requirement of crude oil there too has fallen. Hence, the demand for crude oil has fallen
in so many places. And according to the demand-supply law, if the demand of
something falls, then its price will also fall. But if the supply would be reduced too,
then the price could be kept stable.

2. Fair game!
As a matter of fact, around 30 years prior to today, USA had been an oil importing
country, but around 2010-14 there was a revolution in its oil industries, due to which
USA became an oil exporting country and made USA the world’s no.1 oil producer. It
left Russia & Saudi Arabia lagging. USA snatched away the market share from Russia
& Saudi Arabia. The supply of oil increased & the oil prices fell. Due to this the supply
of oil increased and the oil prices fell. This meant the profit of the OPEC & Russia
began to decrease. Then OPEC thought that they would have to destroy the USA’s oil
industry & keep their share market maintained, if they wanted to keep accruing profits
in the future. In order to do this, the OPEC & Russia decided to increase their
production. Here Russia wanted to attack the US industry in the form of prices and
wants to destroy it. But instead of this if OPEC & Russia would have played a fair
game, because their oil companies were nationalized companies, so the government
could keep funding the companies to keep them running.
 3. Acquire short term plans
Producers, in the short term, may accept prices below their variable cost if they are able
to pay some of the costs they will incur even if oil production shuts down. As time
passes, more and more rigs will stop operating (technically, a few will be kept
operational in order to avoid being compromised) and a new balance supply and
demand will be established at prices that average cost.

Conclusion:
If global demand loses an estimated 20% because of the coronavirus outbreak, this means
that inventory levels will rise. Once global storage becomes full, oil producers have then
two choices: either they lower their prices significantly to stimulate demand or cut their
production. Even if demand were to return to pre-virus levels, it would take a long time to
burn off all that stored crude. Hence what the energy market is telling you is that demand
isn't coming back any time soon, and there's a supply glut. The fall in WTI crude oil futures
will not affect the fuel price in India. As India mostly imports Brent crude which is
comparatively stable at $25.35 per barrel. However further decline in crude oil price can
help Indian government reduce the current account deficit (difference between total value of
import and export) This will improve the value of rupee and keep inflation under control.