Question

The price of oil fell to an unprecedented level during the Monday trading session creating major disruption and fear among oil producers and traders.

1. What contributed to the collapse in the oil price?

2. How did the derivative market facilitate that process?

3. What advice would you provide to oil producers for the next contract expiration?

Answer 1

1. COVID-19 pandemic has resulted in a halt in economic activity, there is no export and import of goods, therefore there is no demand for oil. Despite the announcement of 10% porduction cut there is so much production of crude that it exceeds supply so there is a need to store this crude. This has led to a fall in crude price

2. In Derivative market the buyer of the crude has two options at expiry

a) Either square off the position (ie sell the current month contract)

b) Take the delivey of the crude

Now since there is shortage of space to take delivery of the crude, trader has to square off the position which led to negative prices of crude

3. Oil producers should sell the next month contract so that get have the right to deliver oil to the counterparty on expiry