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May 22, 2020 Friday 02:56:43 PM IST

Covidonomics

Finance

On April 21, a friend of mine tweeted with the photo of a pond. “I bought 10 barrels of crude oil and stored here in a quickly made pond in my backyard. Richer by $370. What a feeling...!”


What caused my friend to post a tweet like this? On April 20, the West Texas Intermediate (WTI) crude oil prices for May contract fell to minus $37 per barrel before settling at $26. WTI is the benchmark for US oil. The May contract expires on April 20 and there were no buyers to take delivery of barrels. An exchange traded fund (ETF) which had 25% stake in the expiring contract dumped its holding at whatever price it could get and this caused the severe negative impact on price. 



THEORETICAL FRAMEWORK


This may be the first time that any commodity was being negatively priced and people were wondering despite the massive production cuts announced by Organisation of Petroleum Exporting Countries (OPEC), why did oil prices turn negative? Microeconomics or price theory deals with the aspects of supply and demand that determines prices.

Most commodities have a price and value even if it is given free of cost. Drinking water is provided free of cost to people in public places but it doesn’t mean that there is no cost involved in supply of the commodity. As population grows, water shortages are expected but people look to the need of water, not the demand for it, according to Donald Stevenson Watz and Malcolm Getz in their classic academic work, Price Theory and its Uses. Higher prices would help curtail the uses of water without creating a shortage. We often talk of free air but in many cities such as Delhi which was suffering from smog causing respiratory problems there was indeed talk of paying a price for quality air to breathe.


The theory of demand states that more of a commodity will be demanded if prices fall. Thus there is an inverse relationship between price and quantity demanded. The theory states that demand will be determined by the price, income of buyers, their tastes and prices of closely related commodities. Closely aligned with the law of demand is the law of supply. The supply curves are direct and positive as more quantity will be supplied at higher prices. In simple terms, a market is said to be in equilibrium when demand matches supply.

Economic theory and also practical experience show that no commodity will have a negative pricing where the seller gives money to the buyer to dispose of the product. However, in actual practice there are some exceptions. In many urban households, money is paid to an agency to take away plastic or e-waste or organic waste. But the agency might be selling it to a recycling unit or a facility that turns organic waste into manure or energy.

NEGATIVE PRICE

The negative pricing for WTI crude oil was caused due to the expiry of the futures contract rather than a 300% overnight fall in demand, although oversupply factors will keep prices depressed, according to Dr Lurion De Mello, Senior Lecturer in the Department of Applied Finance at Macquarie Business School. Many commodities such as Gold, Silver, Copper, Crude Oil are all traded on futures exchanges which are used by the stakeholders in the industry for speculation and for hedging.


The Brent Crude oil prices which are also traded in futures exchanges did not follow the WTI Crude OIl and go into negative territory. This is because countries producing Brent Crude have controlled their production more responsibly and it is not traded significantly in futures to create speculation.

The negative pricing for crude oil was just an aberration in the market with June contract hovering at $20 per barrel levels. Ultimately, crude oil prices are expected to rise to $50 or 60 levels once the pandemic lockdown gets over.For one in a US election year prices tend to be stable and there is also the need to sustain the US shale oil production at viable levels.

DUMPING OR DESTROYING

For most commodities dynamic equilibrium is maintained by the forces of demand and supply. However, this doesn’t mean that market will not have shortages or surpluses of a commodity from time to time. But prices or production normally adjust to such changes to bring market equilibrium.Sometimes we have heard of tomatoes, mangoes and apples being thrown into the streets or rice and food grains dumped into the sea to prevent prices from falling. During a bumper harvest of agricultural crops, prices can crash making it unremunerative for farmers and traders to hold on to the commodity.


Destroying the produce helps reduce the supply and bring some equilibrium. Surplus commodities are converted to a non-perishable form to prevent a price fall or create value. Or it could be to use a commodity for a more pressing need as in the case of rice. The Food Corporation of India announced that surplus rice in their stock will be used to make alcohol-based sanitizers. The ethanol produced from surplus rice would also be used in the production of Ethanol blended petrol which is approved as per the National Policy on biofuels. 

The policy allows conversion of surplus food grains, in case the Ministry of Agriculture anticipates oversupply during the crop year. Remember the grandmother’s wisdom to convert surplus mangoes or lemon to pickles which have a higher shelf life or making fruit syrup to create value and ensure surplus of a commodity is put to good use and not thrown away.

OIL PRICE PREDICTIONS

Crude Oil prices have defied rational behaviour may be because its demand and supply is controlled by a cartel called the OPEC. Oil is also an indispensable commodity from which we derive the product such as petrol, diesel, jet fuel and bunker fuel. It is impossible to imagine transportation without it although there is talk of shifting to electric cars by 2020 the world over.


Many people have failed miserably in predicting oil price movements. A decade ago, many analysts expected crude oil prices to rise to $250 per barrel but it never happened. Kevin Morrison, a leading UK based commodity journalist in his book, Living in a Material World, the Commodity Connection, talks about the oil glut in 1990’s that was caused by Venezuela ramping up its oil production to increase its global oil market share. This policy of increasing market share was reversed when Hugo Chavez was elected in 1998. The election of the former army colonel marked a turning point in the oil price, which bottomed to less than $10 a barrel. This led The Economist magazine to predict in March 1999 that $10 per barrel would last for ever.

NEGATIVE INTEREST RATES

Oil is not the only commodity whose value has gone negative. The US interest rates have also taken the same route. Nobel Prize winning US economist Paul Krugman and columnist in an argument for more federal aid to statesto shore up the economy badly bruised by Covid-19 said that government can go on borrowing vast sums of money cheaply. “ In fact, the interest rate on inflation-protected bonds, which measure real borrowing costs, is minus 0.43%: Investors are basically paying the feds to hold their money.”

The phenomenon of falling prices has also affected wealthy investors in equities with majority of them waiting for a drop in prices before buying again. A poll done by UBS Global Wealth Management showed that majority of investors expect bearish trend to continue with prices to fall 5 to 20% before they will start buying.


MONEY IN YOUR HANDS

Every talk of the pandemic ends up with the staggering figures lost in terms of Gross Domestic Product either at state or central level. That is when stimulus packages are thought of to get more money in the hands of the rural people who in turn will spend and create demand for consumer goods industry and also capital goods industry. There seems to be optimism in the rural sector as government expects India’s agricultural sector to grow 3% and the agriculture ministry claimed to have disbursed Rs 17,896 crore to farmers during lockdown. The agriculture sector was functioning smoothly and there was no shortage of food grains, milk, vegetables and dairy.The sown area for summer crops was 57,07 lakh hectares which was 38% higher than same period last year. India government has signed an agreement with Asian Development Bank to avail $1.5 bn to support the government’s response to Covid-19 pandemic with focus on disease containment and preventions as well as social protection for the poor and economically vulnerable sections of the society.


Sreekumar Raghavan

Sreekumar Raghavan is an award-winning business journalist with over two and a half decades of experience in print, magazine and online journalism. A Google-certified Digital Marketing Professional, he specialises in content development for web, digital marketing and training, media relations and related areas. He is the recipient of MP Narayana Pillai Award for Journalism in 2001 and holds a bachelors degree in Economics and Masters Degree in Mass Communication and Journalism from Kerala University.

 

 

 

 


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