The Covid-19 pandemic is the root cause of the fragile state of the global economy as well as the markets. While the global indices were staging episodic recovery, the latest bout of volatility has come in, thanks to oil prices.

Before getting into the dynamics of what’s wrong with oil or if there is something really that wrong in oil, a quick look at how have the Indian benchmark indices traded on April 21; the 30-share S&P BSE Sensex recorded its day’s high at 30,900.12–-over 747 points, or 2.36%, below its Monday’s close of 31,468 points. Similarly, the National Stock Exchange’s Nifty 50 recorded its Tuesday’s high of 9,044.4 points-–over 217 points, or 2.35%, below its previous day’s close of 9,261.85.

At 30,636.71 and 8,981.45 points, the Sensex and Nifty 50 closed over 1,011 points (-3.20%) and over 280 points (-3.03%) lower from their Monday’s close. The level of panic can be gauged by the Sensex and Nifty 50’s respective overnight decline of over 1,269 points (-4.01%) and 352 points (-3.81%) to the day’s low of 30,378.26 and 8,909.4 points, until 2.30 p.m.

The question now is what went wrong with oil, to cause such havoc. Monday (April 20) saw the price of the May 2020 futures’ contract of the West Texas Intermediate (WTI) crude fall from around $18 a barrel to a negative $39 a barrel. While this happened for the first time in history, there is merit in not jumping to a conclusion on the future of the global economy.

According to Martin Rats, Amy Sergeant, and Devin McDermott, analysts with Morgan Stanley, whilst the oil markets are oversupplied and the near-term outlook does not look encouraging, such a sharp sell-off cannot be explained by the fundamentals of global supply and demand alone. While Rats, Morgan Stanley’s equity analyst and commodities strategist, and Sergeant, firm’s commodity strategist, are based out of London, McDermott, also an equity analyst and commodities strategist, is based out of New York.

In their attempt to explain the dynamics, the trio noted the basics of WTI trade and expiries in a note during the market hours on April 20; they explained that oil futures contracts relate to specific delivery periods, and the front-month WTI contract, which made history on Monday, is for crude oil delivered in May. However, the contract was close to expiry, and at the end of Tuesday (April 21), the June contract becomes the new front-month contract.

Unlike Brent, the benchmark used for two-third of the world’s oil contracts, the WTI contract is settled through physical oil delivery. This means that on the day of expiry the owner of the contract gets the contracted barrels of crude oil. “The oil market has a large number of financial players who cannot take physical delivery, so these participants will need to sell their forward contracts ahead of expiry to physical players who are in a position to receive those barrels,” the trio explained.

The trio further highlighted that the pricing point for the WTI is a hub in Cushing, Oklahoma, where this crude is traded and storage is usually available. The trio also added that as per the U.S. Department of Energy, on April 10, approximate 55 million barrels of crude oil were stored near Cushing. “The oil market is sharply oversupplied, so inventories at Cushing are rising, currently at a rate of 6-7 million barrels per week,” the trio added. “The highest-ever amount of crude oil stored at Cushing is 69 million barrels, which occurred in April 2017.”

With some capacity expansion since then, the trio estimates current total usable capacity at around 79 million barrels. In the trio’s view, the remaining storage capacity will probably be exhausted in about four weeks. “Starting from April 10, this puts ‘tank tops’ in the middle of May,” the trio noted. “After that, there is probably no more storage capacity available.”

And the historic contract that expired on Monday would lead to the delivery of oil barrels precisely around that time. “Financial players that still owned May contract have probably been eager to offload these, but without physical players with storage capacity, the bid in the market dried up, allowing prices to plummet to this deeply negative value,” the trio noted further.

“Although oil prices are low, there is no easy way for financial investors to benefit from this,” the trio cautioned; because only those who can take physical delivery can make a financial gain out of this type of contract. “What the price action is telling you is that there are very few market participants – if any – in that group anymore,” the trio noted.

According to David Chao, global market strategist for Asia-Pacific (ex-Japan) at Invesco, a U.S.–based investment management firm with over $1 trillion in assets under management (AUM), the WTI futures’ collapse and close at minus $13 per barrel means that producers were essentially paying buyers to take physical delivery.

In his April 21 research note, Chao explained that although Covid-19 may have originally kick-started the month-long volatility in oil prices, the supply spat between Organisation of Petroleum Exporting countries (OPEC) members Saudi Arabia and Russia sent oil prices in a tailspin. “A recent OPEC deal to cut nearly 10 million barrels a day of oil supply in May and June has done little to an already rattled market,” Chao wrote.

Further, Chao calls April 20’s WTI move a technical aberration, which does not truly reflect what’s going on in the commodities world. The minus $13 a barrel is the contract price of May delivery that oil traders have fled from, whereas the price for delivery in June 2020 is $20 a barrel; and for June 2021, it is $35 per barrel. Meanwhile, Chao highlights that the active June 2020 Brent crude contract, a better indicator of global oil prices, was down only 3% at $25.49 a barrel. “Although Brent may not have reacted to the same extent as WTI, the direction is still the same,” Chao noted.

The recent volatile oil price movements, in Chao’s view, are due to both supply and demand factors. Chao points out that the recently announced OPEC supply cuts are around the corner next month and eventually U.S. shale producers are also expected to cut supply. In his view, producers have seen supply/demand cycles before and will adjust supply accordingly.

Also, the market is also now fully aware of the storage capacity constraints. “The bigger more systemic problem I worry about is on the demand side–due to the economic recession caused by the Covid-19 lockdown,” Chao noted. “Market participants did not expect the outbreak to become a pandemic, couldn’t fathom that the lockdowns would be enacted globally, and are now uncertain about how quickly the lockdowns can be released or even if the lockdowns may need an adaptive release.”

Chao is of the view that the commodity and equity markets are pricing in different economic scenarios. While the U.S. shale oil market is undergoing a painful adjustment similar to 2014-2015, when, the global recovery helped drive the price of oil back up as China engaged in a massive stimulus. “It’s becoming apparent that the U.S. and EU (European Union) will experience a much more gradual, tentative recovery than in the past crisis and even China may not see a strong V-shaped recovery as it once did, as consumers remain wary even after the lockdown has ended,” Chao added.

In his baseline scenario, Chao expects growth to bounce back in certain markets that experience an initial release, but he foresees overall global growth over the next year to be weak and tentative. “I think that oil and other growth-geared commodities are accurately pricing in this scenario whereas equity investors are pricing in more of a mild recession,” Chao noted.

While such steep fall in oil price is negative for global economy and markets and Indian equity indices are bound to mirror the volatility seen in their global peers, what is important to note is the fact that India is an oil importer to the tune of 4 million barrels a day; 1.4 billion barrels a year. “The country has been benefitting from the falling prices of oil for the last five years, when oil dropped from a peak of $110 per barrel to $50-60 per barrel last year,” says Amit Bhandari, fellow, energy and environment studies, Gateway House. “The negative price has no direct impact on India or Indian oil prices as this have taken place due to crude oil produced and traded within the U.S.”

At best, Tuesday’s 4% fall in the benchmark indices is a good entry point for cautious investors who are in a dilemma around the bottoming of the Indian market.

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