Over the past week, we have witnessed an unprecedented collapse in the West Texas Intermediate (‘WTI’) May futures contract, which on Monday closed at -$37.63 per barrel. The deep-dive into negative territory was primarily driven by an excessive supply of oil, with no demand, and a lack of storage facilities.

WTI is a physically-settled contract that requires storage facilities, which will reach their capacity as early as May 2020, because of the low demand driven by the global isolation measures to counter the coronavirus. By introducing lockdown measures, the demand for oil reduced, thus creating a back-log of supply, and since oil production levels have been maintained, the supply overshot demand. Therefore, positions were rolled from the May futures contract that was to expire on 21st April 2020 to June or even later-dated contracts, resulting in the front-month contract volumes drying up and the price to take a nosedive. 

Chart 1: WTI Price vs. Storage Capacity

Source: Bloomberg

                                                                                                                                          

Although WTI danced in the negative territory, Brent Crude remained at mid-$20 per barrel. The displacement between the two contracts is due to the way the two contracts are settled. As mentioned above, WTI is a physically-settled contract,  which needs storing at a major US hub. In contrast, Brent can be cash-settled, illustrating the market sentiment as opposed to acting as a physical barometer. However, when Brent Crude is settled physically, it is typically stored in vessels in the North Sea that have ample storage capacity and are more portable as compared to the landlocked US hubs.       

Chart 2: Spread of Brent vs. WTI Crude Prices

Source: Bloomberg

To combat the root cause of such ultra-low oil prices, which is the oversupply of oil in the markets, the Organization of Petroleum Exporting Countries and other members that make up the OPEC+, have agreed to reduce their combined production. The accepted solution is to cut output by 9.7mn barrels/day, c.10% of global supply, until June 2020, and by 7.7mn barrels/day for the remainder of 2020. However, many nations have already acted before the 1st May deadline in hopes to stabilise oil prices but for the near term this will not be enough.

Therefore, given the recent significant dislocation in supply and demand and the increasing storage difficulty, can we potentially see the scenario repeat itself? It is possible, because of the current global lockdown we currently face. Flights have been cancelled, which make-up more than a third of global demand, and typical day-to-day travel and consumption have tremendously reduced. Thus, in the near-term, the demand as it currently stands, will not increase, which will result in oil prices to remain at ultra-low levels and WTI to potentially test negative levels in upcoming front-month WTI futures contracts.

How is this impacting the economy?

The recent spread of the coronavirus has had a notable impact on the global economy. In 2020 alone, the IMF predicts that the economy will contract by 3% in its World Economic Outlook published last week. In the same paper, the IMF mentioned that due to the overall reduced demand in oil, oil prices could remain under $45 per barrel until 2023.

In particular, the IMF has predicted that Venezuela will probably see the most substantial impact to its GDP compared to the other oil-exporting nations. In 2020 alone, Venezuela’s GDP could contract by 15%. Whereas others from the same region, such as Mexico, Brazil, Colombia, etc. will see an average GDP reduction of c.6%. Middle Eastern oil-exporting countries will also see a contraction in their GDP, but the impact will be less pronounced compared to that seen in South America. The predicted average GDP reduction of the oil exporting countries in the Middle East is c.4%. Moreover, the group of countries that produce oil in Sub-Saharan Africa will see a GDP decrease of c.3%.

Chart 3: Forecast of GDP Contraction in 2020

Source: IMF

Additionally, the recent developments in the oil markets coupled with the spread of the coronavirus pandemic have led to central bank action from Russia. On Friday, the Bank of Russia adjusted its monetary policy by cutting its base interest rate by 50 basis points to 5.5% and has kept the door open for more cuts. The central bank has also lessened its economic forecasts, predicting that Russia’s GDP will weaken by 5.5% in 2020.

How does it affect currencies?

On the back of the drop in oil futures, the USD rallied against a group of six major currencies that make up the US Dollar Currency Index. The Index managed to hit a two-week high of 100.80, before coming back down to current levels of 99.98. The driver for the rally was primarily the risk-off sentiment and overlaying it with the fact that both the CAD and NOK are oil-linked currencies, a depreciation in both currencies further enhanced the USD rally.

Chart 4: USD Index

Source: Bloomberg

On the day, as the WTI futures slid into negative territory, the USDCAD rallied to a high of 1.4136 from lows of 1.4014, showing the positive correlation between CAD and oil. However, the pair has partially recovered, as it is currently trading at 1.4045. Similarly, USDNOK showed a slight rally on the day where it increased from 10.41 to 10.67 and is presently trading at 10.55.

Ultimately, the last week has shown everyone that even physical commodities, if stressed enough, can have negative prices. It has had an impact globally, but particularly the major bearers of the shock are the many oil-producing nations. USD has benefitted from the risk-off sentiment and could potentially see a further uptick if the supply does not come back in line with demand. At least for the coming months, we may see WTI testing negative levels again, but how long this continues for is the real question.

Author: Latif Ismail