Why We May Not See Negative Oil Prices Again Anytime Soon

Oil field pumps. Image source: Pan Demin © 123RF.com

The word "unprecedented" has been thrown around a lot over the past several weeks to describe the substantial impact that the coronavirus crisis is having on the global capital markets. The pandemic is affecting all facets of modern life, from the way people adapt to working from home to the way national governments conduct their policymaking. All of these developments are likely going to have some profound and long-lasting consequences for societies in the months and years to come.

One of these vastly unexpected ramifications for the global capital markets stemming from the coronavirus fallout is the energy market's turmoil of last month. At one point, the price of West Texas Intermediate oil plummeted to the 'unprecedented' -$38 per barrel, which was the high point of an exceptionally tempestuous week for the precious commodity.

Arguably, the expiration of the May futures contracts in Late-April served as the catalyst for this massive downturn in the price of oil, which prompted heightened trading activity amidst an already turbulent market. Given the still relatively fresh memories of this momentous occasion, some market experts have started to dread the upcoming 19th of May, which is when the June contracts are set to expire. They are concerned with the prospects of a repeat of last month's situation, and a new oil crash.

While most traders are justified in preparing for new rounds of adverse volatility to hit the market around the time of the June contracts' expiration, there are also compelling reasons to expect the market to survive the rollover date relatively unscathed.

To understand why the energy market could be jolted next Tuesday, without that having merely as detrimental consequences on the price of crude oil comparable to last time, the chain of events that led to the previous collapse in the price of the liquid gold needs to be carefully examined.

The first major factor that contributed to crude's price crash last time was the tremendous glut in global supply that was left even as the rift between Saudi Arabia and Russia, which led to the outbreak of the price war in the first place, was finally being breached in early April. That was so due to the discrepancies in the agreements that were reached during the last OPEC+ meeting in Vienna, which effectively terminated the price war, and the selected timing for implementing set protocols for production cuts.

Essentially, the announcement of the price war's termination had the desired effect of curtailing the adverse uncertainty that was looming over the energy market at that time; however, no actual production cuts were implemented right away. That is why the global output continued to increase throughout April, thereby extending the size of the supply glut, leading to the eventual price collapse.

Back then, the OPEC+ was slow to react to the developing rift between the global supply and muted demand internationally, which was caused by the national lockdowns and closedowns of many economies. Therefore, the aggregate supply and demand disequilibrium was allowed to persist until May, which was when the long-anticipated production cuts were finally getting started.

Simultaneously, many countries have either started to ease off their restrictions or to draw out plans for the gradual lifting of these measures in the near term. All of this has led to the moderate stabilisation of the global demand for crude, as nations are now slowly allowing for their general economic activities to pick up speed once again. That is why the expected surge in aggregate demand accompanied by a steady decrease in net production is likely to alleviate the strain felt by the energy market, albeit at a moderate pace. All of this seems to lessen the probability of crude's price falling to near-negative or even sub-zero levels once again.

The second contributing factor in the crucial chain of events that led to last month's oil crash was its timing. The general market uncertainty that was plaguing most capital markets - it remains very much so an active impediment to global growth to this day - was especially pronounced around the same time the price of crude plummeted.

In mid-April, the number of newly confirmed cases of COVID-19 globally was arguably still on the rise. This raised concerns over the prospects for an eventual economic recovery due to the evidently deteriorating healthcare crisis, which made projecting the anticipated stabilisation quite difficult. It was an unfortunate coincidence that the height of the supply glut concerns coincided with the uncertainty caused by the undetermined risks for the global economic activity. The two factors amplified each other's magnitude, which resulted in the additional pressures exerted on the market for crude.

The third and final contributing factor was once again connected to timing. It had to do with the aforementioned termination date of the May futures contracts. At that time, traders were taking into account the other two contributing factors, which led them to believe that the rollover date for the June contracts was going to be marked by huge amounts of volatility regardless of the prevailing market sentiment.

That is how the expiring futures contracts served as a catalyst for all of the supporting factors, which ultimately prompted traders to bet against oil, resulting in the massive execution of short orders in a relatively short period of time. Consequently, all underlying factors – from the broader supply and demand disequilibrium to the short-term traders' speculations – inlined to create the necessary conditions for the emergence of the 'perfect storm' that we witnessed in the energy market.

We can now conclude in hindsight that the price of crude oil plummeted to nearly negative $40 in Late-April because everything that could have gone wrong did go wrong for the precious commodity.

And that is why the situation is different today, and the price of oil is unlikely to turn negative once again, even as the June contracts' expiration date nears closer. Nevertheless, the underlying risks should not be underestimated because the energy market continues to struggle from the same headwinds, albeit much less so.

This moderate optimism stems from the congruency of the underlying factors in the oil market at present. For one thing, the aggregate supply and demand equilibrium in the market seems much more stable than it did a month prior, even though it is still far from the desired levels. And for other, even though the international healthcare crisis remains prevalent, the efforts by nations to work towards opening up their economies have eased the global uncertainty. Subsequently, the underlying economic tensions are arguably smaller compared to the situation in April. All of this means that traders would have fewer reasons to bet against the price of crude oil.