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Oil Monday. How will lower prices affect Ukraine?

22 April 2020
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Previously, oil prices would sometimes fall to a few dollars when oil storage tanks were on the verge of being filled up but they never crossed the zero mark. What caused the oil “zeroing”, what is the current situation in the oil market and how will it affect Ukraine’s economy and relations with Russia?

The reason behind the negative price is the sharp drop in oil demand due to the partial shutdown of the economy and the reduction in fuel demand. Oil-trading countries are not shutting down production yet waiting for the quarantine to be lifted and the economy to be relaunched – the industry will start operating at full capacity bringing a sharp rise in demand.

As for the WTI prices hitting zero, it is important to understand that we are not talking about oil prices in general but about the price of futures contracts to buy oil at the set price. The prices jumped one day before the close of May futures. The June per barrel price at the time was about 20 dollars.

How does the oil market operate?

A futures contract is a commitment to supply a particular commodity (or, sometimes, its financial equivalent) in the future. The oil futures market trades in derivatives, that is, through contracts that allow you to buy and sell oil, roughly speaking, without having it on hand. But WTI oil futures contracts on the Chicago Board of Trade are physically settled. And when the contract expires, on the following day, you have to either buy this oil or deliver it to someone. The oil collection point is the city of Cushing in Oklahoma (USA), just near Chicago, having a large oil hub. 

As the market itself has changed a lot in the last couple of decades, with its many more financial players and dramatically increasing volume – financial players, real sector players, oil companies and a lack of clarity about whether they use futures contracts to cover their risks or just play their games – there are more and more problems related to Cushing. Logistical problems in the first place.

For one, the hub’s capacity is limited and it is unable to always handle such volumes of oil. Shortly before the collapse, Cushing was physically 70% full with all the other capacities already contracted. Also, it cannot be expanded quickly (due to being an on-land facility) like it could be done in the ocean by fitting tankers. Therefore, futures prices jump at expiration – they have fallen sharply several times before, although never to a negative value. As soon as there is a bottleneck in the system – a shortage of oil with no possibility to supply it, or, conversely, a surplus with no possibility to collect new oil, weird situations occur when traders may even be paid to take the oil.

This is exactly what happened on April 20, and those who had free tanks or storage facilities in the Oklahoma area made money on it.

By the way, a similar situation occurred on Monday in the spot (i.e. immediate delivery) market – the price of Russia’s Urals oil also fell below zero there. What does this indicate? That the world oil market is overloaded.

Oil will cost nothing now?

This situation should not be taken as an indication that oil is now worthless. Already on April 21, deliveries of various oil brands, including WTI, cost 20+ dollars per barrel for the next month – however, during the day, the price of the nearest WTI futures contract fell to 11 dollars per barrel, with the prices for Brent also falling below 20 dollars per barrel.

If quarantine is extended indefinitely and production is not curtailed, there will be so much oil that it will be nowhere to be stored and the prices will fall. An answer to this will still be curtailing the production. Crude production has not been suspended because the economy is expected to get back on track soon.

There was another foreign policy factor, namely OPEC, contributing to this situation. For a long time, OPEC member countries could not agree among themselves on limiting production in response to the oversaturated market. Russia and Saudi Arabia waged war on each other, then Mexico joined in with their own position, and consequently, the already oversaturated market kept being flooded with oil.

Previously, they used to come to terms and curtail production – primarily Saudi Arabia as the largest producer – controlling supply on the market. And now everyone needs cash, so oil excavation does not stop.

What are the benefits for Ukraine?

This situation is definitely advantageous for us because we have the price range on exports and imports. For instance, the agricultural sector earns a margin on the difference between the prices of imported energy and exported products. Fuel makes a significant part of the farmers’ costs.

Because food prices are more or less stable (although some prices, such as corn, have gone down) and energy prices have fallen, our margins will rise. Although food prices can also go down following the energy prices – cheap oil, cheaper gasoline, and, respectively, lower cost of grain production in which fuel price is partially embedded. Let us see how this will affect the price of natural gas that we also produce and import, and how it will affect the economic situation as a whole.

Can we expect similar price jumps in the future?

The cyclical nature of the oil market is as follows: periodic oversaturation, the prices fall, the many oil projects and alternative energy sources become unprofitable or uneconomic resulting in reduced market supply and rising prices in the long run in response to a long-term supply decline, and then the suspended projects start to unfold.

It is a long cycle, because oil projects require a lot of investment and take a long time to develop. In a few years this should result in an increase in demand again. But all this is superimposed on changes in technology gradually moving away from fossil fuels towards green energy and the like.

Hard times for Russia?

I would not overstate the impact of these factors on Russia, because like many other oil economies they have a national welfare fund and other reserve funds to “skim the cream” off the oil market when prices are high, and use them when prices are falling. Now they dip their hand into those funds to mitigate the impact on the economy.

Thus far, this has not made Russia very vulnerable, even though they, too, are suffering from the coronavirus crisis like others, apart from the oil crisis.

Maybe they will eventually decide that it is critical for them to lift the sanctions because the population is becoming dissatisfied with the regime, but unfortunately, it is impossible to say that Russia will collapse tomorrow.

Authors
  • Pavlo Kukhta, Deputy Chair of the Strategic Advisory Group for Supporting Ukrainian Reforms (SAGSUR)

Attention

The author doesn`t work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations