Why are Oil Prices Plummeting?

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April 20, 2020 1:11pm NYSE:USO

NYSE:USO | News, Ratings, and Charts

  • Brent-WTI is a location, quality, and a political spread
  • Brent’s premium has trended lower, which is a function of the price of oil
  • Contango tells us the world is running out of places to store crude oil

The 9.7 million barrel per day production cut in the oil market may have been the most substantial in history, but it was not enough to spark a recovery in the price of the energy commodity. OPEC, Russia, and producers around the world agreed to the two-month reduction that would scale back in two months, depending on market conditions. However, the price of nearby May NYMEX crude oil futures fell from a high of over $28 per barrel on Friday, April 9, to a new record low on April 20 as May futures rolled to June. The price action in the oil market in the aftermath of the production cut tells us the problem with the price does not come from the supply side. It is the demand side of the fundamental equation that is creating price carnage in the oil market.

Meanwhile, the price of the Brent benchmark crude oil futures contract in June fell to a low of $26 per barrel at the start of this week. The most recent low was at $21.69 on the continuous contract. Brent is the pricing mechanism for approximately two-thirds of the world’s crude oil, while the NYMEX WTI benchmark reflects around one-third of the world’s pricing. The Brent-WTI spread is a quality, location, and political risk indicator that provides clues about the price direction of the energy commodity at times. The term structure in the oil market is a monitor for supply and demand. The United States Oil Fund (USO) and the United States Brent Oil Fund (BNO) are the ETF products that track the prices of WTI and Brent futures higher and lower.

Brent-WTI is a location, quality, and a political spread

The Brent North Sea price of crude oil is the benchmark for crude oil production from Europe, Africa, and the Middle East. Approximately two-thirds of the world prices the energy commodity via the Brent price that trades in the futures market on the Intercontinental Exchange.

The West Texas Intermediate crude oil benchmark is the pricing mechanism for crude oil from North America. WTI futures trade on the NYMEX division of the Chicago Mercantile Exchange. The Brent-WTI differential is a location spread.

WTI crude oil is lighter and sweeter than Brent petroleum, meaning that the WTI crude oil has a lower sulfur content. It is less expensive to refine WTI crude oil into gasoline. In contrast, the heavier Brent crude oil is preferable for processing into distillate products such as heating oil, jet, and diesel fuels. Therefore, the Brent-WTI relationship is also a quality spread in the oil market.

Finally, since over half the world’s crude oil reserves are in the Middle East, the most turbulent political region on the earth, the Brent-WTI spread also serves as a political risk monitor as it often rises when supply concerns in the region increase.

Since the Arab Spring in 2020, the price of Brent crude oil has traded at a premium to WTI for two reasons. First, political concerns over the Middle East have kept a bid under the price of the Brent futures. Secondly, the rise in output from the US has caused pressure on the price of WTI futures on a relative basis. The Brent premium over WTI tends to rise and fall with the price of crude oil. In 2020, the spread hit a high of $6.70 per barrel with a premium for Brent during the first week this year when NYMEX crude oil rose to $65.65, and Brent hit a peak of $71.99 per barrel on January 8.

Brent’s premium has trended lower, which is a function of the price of oil

With the price of crude oil tanking, the Brent-WTI spread has been trending lower throughout 2020.

(Source: CQG)

As the weekly chart shows, the Brent premium over WTI has been trending lower since May 2019. In 2020, it has traded from a low of 17 cents per barrel to a high of $6.70. On the June futures contracts, it was at the $3.78 level on Monday, April 20. Sometimes the Brent-WTI leads the price, and at others, it follows. The current trend in the spread is a validation of the bear market in the energy commodity.

Contango tells us the world is running out of places to store crude oil

Contango is a condition where prices for deferred delivery are higher than for nearby delivery. A widening contango points to a higher nearby supply than demand. When deferred prices are lower than those for nearby delivery, backwardation points to market tightness or a condition where demand is higher than nearby available supplies.

(Source: CQG)

The chart of the price of NYMEX crude oil for delivery in June 2021 minus the nearby June 2020 futures contract shows that the term structure moved from a $6.03 backwardation in early January to a $13.02 contango on

April 20. The substantial move of $19.05 per barrel in the spread reflects the evaporation of demand in the oil market.

Over the same period, the same spread in Brent crude oil moved from a $7.98 backwardation to a $12.83 contango or $20.81 per barrel. The forward curves for both WTI and Brent crude oil reflect massive levels of oversupply and dwindling availabilities of places to store the energy commodity during the current period of price carnage.

The price action in the Brent-WTI spread and the term structure for both benchmarks are telling us that the demand problems for crude oil continue, and lower levels are likely on the horizon unless output falls dramatically.

Meanwhile, nearby crude oil futures dropped by over $56.80 per barrel from the January 8 high to the April 20 low. At Monday’s low, crude oil fell below the 1986 bottom when the energy commodity traded to a low of $9.75 per barrel. Years ago, the price of onions moved to zero on the futures exchange. Traders bought at zero, dumped the onions and sold the burlap bags for a profit. The problem for oil these days is that there is nowhere to put the energy commodity.

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Investors Beware: It’s Still Really Bad Out There!

The United States Oil Fund LP (USO) was trading at $3.83 per share on Monday afternoon, down $0.38 (-9.03%). Year-to-date, USO has declined -68.11%, versus a 7.41% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #65 of 109 ETFs in the Commodity ETFs category.

About the Author: Andrew Hecht

andrew-hechtAndrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.

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