Crude Oil: The Big Black Bet
Executive Perspective
Crude oil prices are critical for Indian economy as its demand, supply, output and other factors directly affect the Indian Trade Deficit. The article provides insight on how few hands control the fuel and enjoy the benefit of regional and demographic imbalance thereby impacting economies. Indian economy which till date has been dependent on Imports of crude is often impacted by sharp changes in crude prices. The US weekly Inventory figures and how the derivatives market for Crude reacts to each and every headline of the day from US and OPEC members has been considered in this article. The once in a lifetime event of negative prices which has at times been a theoretical discussion but had been a practical experience during the times of Pandemic 2020. Overall the article provides a broader view on what exactly is “The Crude Phenomenon” which straightforwardly dents almost each and every sector of the economy.
1. Global Energy Landscape & India’s Import Dependency
Crude oil prices drive economic health of many countries. From fueling to farming to ferrying to flying, purchasing power of every single penny starts to decline the moment crude starts to surge. Global economy has seen major swings in the price of this mineral ranging from $150–$165 a barrel during the time of Global Financial Crisis 2008 to $11–$19 a barrel during the times of pandemic’2020 when there was lockdown across the globe.
Oil rich countries who have a major chunk of their GDP contribution by exploration and export of oil are United States, Russia, The Gulf (Saudi, Kuwait, Iran, UAE), Venezuela, China and others who directly or indirectly control almost 80% of the worldwide production of this black gold.
Heading towards India. We do not have enough oil reserves and thus, import almost 85% of our crude oil requirement. The dollars we spend on this mineral have always made a stiff and strong impact on our finances. During the year 2019-20, crude oil imports amounted to $102 billion of total $467.19 billion of imports, i.e., of every dollar spent on import, 0.22 goes to oil, and thus it can be conceived that crude import contributes maximum to the trade deficit.
As far as data for the fiscal 2019-20 is concerned India stands next to China and United States in terms of crude oil imports at around 48–50 lakh barrels of crude being imported in a day. To make it more simple 159 liters make a barrel.
2. Key Drivers Widening the Trade Deficit
Routing to some major factors, predominantly related to crude that widen the gap between India’s import and export and thereby funding the trade deficit are:
• Rupee to Dollar Relationship
Being an imported product, disbursement for crude has to be made in US dollar. Rising crude prices, directly controlled by thirteen OPEC members leads to much higher outflow of foreign reserves contributing to widening of current account deficit, weakening the rupee and accelerating inflation. The rising oil imports and depletion of foreign reserves directly hinder country’s GDP. Again Indian rupee has been on depreciation treadmill against the US dollar where, during the times of Global Financial Crisis 2008 the average price of one dollar was ₹ 50 and today, it is hovering at around ₹ 75 a dollar – meaning almost 50% depreciation in a decade or so.
• Geo-Political Scenarios
Intensifying geo-political risks post implementation of Iranian Oil Sanctions, Yemen and Syrian War, Fire at Saudi oil facilities and others have led to the assumption that geopolitical risks have uncontrolled impact on global oil prices. Considering the supply and demand relationship, OPEC oil output has hit its 4-year low in Apr’19 post the political tensions gearing up in Iran and Venezuela, both being OPEC members.
• Derivatives
Market participants are buying and selling crude oil contracts, not in delivery form, but in the form of futures and options. Airlines and other end users use derivative contracts like futures, to hedge their treasury against swing in oil prices, while speculators drive those prices upwards or downwards. Slight movement in prices imply variation in millions of dollars either way.
• Duties and Other Levies
To curb imports, government levies duties to reduce the reliance on imports, but since crude being the product which by default has to be imported attracts custom duties at ₹ 57.2 per ton principally increasing the oil prices and funding the exchequer.
- Basic Custom Duty: ₹ 1 per ton
- National Calamity Contingent Duty (NCCD): ₹ 50 per ton
- Countervailing Duty (CVD): ₹ 1 per ton
- Social Welfare Surcharge: 10% calculated on the total of the above three duties (₹ 5.2 per ton)
• Supply and Demand Correlation
The original supply and demand correlation sometimes doesn’t hold good for crude as the power to concentrate and control the same lies in very few hands whereas the consumption is done by almost everyone across the globe, in some form or the other.
• Concentration of Oil Reserves
Oil reserves are viewed as a proven reserve where the probability of extraction of oil is ≥ 90%. Venezuela (the crisis hit country as on date) has the highest quantum of reserves, but the density of crude is hard enough, making it difficult to process. Other economies where crude reserves are abundant are Saudi, Iran, Kuwait and others. Since these economies have built-in reserves, they straight forwardly control the supply and prices.
“Crude prices in India are not driven by the rising market for it, but by the ability to pay for it.”
3. Crude Oil Classification: Refining Economics & Quality Grading
One of the major attribute to the crude pricing is of “Maximum wealth in Minimum hands”. OPEC countries account for almost 70 to 78% of global oil reserves leaving balance in the hands of US, Russia and China, but since the consumption pattern of the Non OPEC countries is too high, i.e. they consume what so ever they can produce, they are second pioneers to determine the pricing schema.
The genesis of Crude Oil classification which the global refiners take into account while calculating Cost of production and also the related bottom-line is as below:
1. Sweet v/s Sour Crude
Classification of Crude grade as sweet or sour depends on the proportion of Sulphur content in it. According to New York Mercantile Exchange:
- Sweet Grade: Sulphur content < 0.50%
- Sour Grade: Sulphur content > 0.50%
In layman’s term Sulphur is something which is not desired in crude and hence sweet crude is more desired and demanded and therefore valuable.
2. Light v/s Heavy Crude
Classification of crude oil into Heavy and Light depends on oil’s relative density based on American Petroleum Institute (API) gravity. In simple terms this test measures how heavy or light is crude in comparison to water. The lower the gravity the heavier the fuel:
- Light Crude Oil: API > 35
- Medium Crude Oil: API ranging between 26–35
- Heavy Crude: API < 26
Light grade of crude is less expensive to refine as it has higher percentage of light hydrocarbons which can easily be refined.
4. Global Benchmarks, Inventory Cycles & Derivatives Trading
Global Benchmark for Pricing: Now particularly in respect of pricing, there are two benchmark grades of Crude globally. The WTI in the United States and Brent Crude in rest of the world. West Texas Intermediate (WTI) is standard for US oil prices and Brent Crude which comes from Northern Europe acts as International Standard for Oil prices globally.
Crude Oil Inventory: Another important aspect which cannot be overlooked and which influences the price of Crude is the Level of Inventory. When oil inventories rise, derivative traders question the demand levels for oil at the current price and tend to square off their positions, causing a price retreat and vice versa.
The U.S. Energy Information Administration (EIA) provides weekly update on crude oil inventories in the United States specifically in Cushing (Oklahoma), the US Crude Oil Store room. This weekly data provide insight on how is the US Oil moving from production areas to refineries.
Oil stockpile provides very essential reflection into one of the important fundamentals of the overall market i.e. The level of Supply, meaning the level of supply influences prices. Oil prices can react spontaneously following the US’s weekly inventory report if they are at a variation from analysts’ expectations. Total inventory levels are also significant because weekly inventory adjustments are taken in the reference of the overall level. If inventory level is low and there is a good weekly expectation on inventories, prices could see a sharp rise. If the records provide some other picture where we have abundant and heavy supply weekly inventories continue to increase, oil prices can experience decline.
Crude Oil as Derivative: Further going ahead in respect of trading of Crude Oil derivatives in the Indian Commodity market, it is a conceived notion that Crude is one of the most actively traded commodity. At the Multi Commodity Exchange (MCX) commodity exchange:
- Crude Oil Main Contract: Unit size of 100 BBL (BBL refers to Barrels of Oil).
- Crude Oil Mini: Contract size of 10 BBL.
At the time of writing of this article, January’21 crude oil futures are trading in the range of ₹ 3400–₹ 3600 per contract.
Now the interesting theme in respect of trading in Crude Oil Derivatives is that at times it is the most volatile commodity to trade in, whether it’s an economic report or tensions in the Middle East, which can exacerbate price movement. Supply and demand determine the price, but the market also moves on sentiments and emotions, especially with retail traders who day trade in crude derivatives. If tensions escalate in the Middle East, there’s no denying to the fact that possible supply disruptions are hotcake, and traders often have to react within seconds to help themselves out from the position.
5. The Unprecedented Crash into Negative Crude Prices
In the recent past, negative crude prices were red hot in the market, wherein it was believed that people will get paid to buy crude, but the picture behind the curtain was altogether different. West Texas Intermediate commonly known as WTI is light sweet grade of crude that is transacted at the New York Mercantile Exchange’s (NYMEX).
In Apr’20, WTI crude was trading at negative $37 per barrel. This was the first time in the history of crude futures that prices were negative, which was due to sudden crash in demand due to pandemic’20 and price/output war between Russia and Saudi Arabia – Two major oil giants. Russia decided to increase its output from 01st April, 2020 and in response to the same, OPEC too decided to increase the production.
As storage facilities crossed their neckline, the prices started pushing in negative territory. WTI grade of crude is different in a way that it is linked to physical delivery of oil, and as the delivery date of WTI grew near, the contract holders began selling their contracts, resulting in massive sell off and prompting the prices to dive into negatives.
Fallout on Capital Market Intermediaries & Indian Brokerages:
The above short story has made big holes in the pocket of capital market intermediaries, leading the global markets to observe sudden sell-off. According to one of the largest brokerage house in India, the day when this unprecedented event of negative oil prices occurred, the brokerage house suffered loss of crores of rupees.
On each overnight carried crude contract brokerage house suffered loss of some 2 lakh rupees. The reason was simple – margin call. However, situation rebounded quickly and again the futures were trading in positives.
6. Endnote: The “4D” Vulnerability of the Indian Economy
Bundling up the above facts, out of the total crude requirement in the hydrocarbon and gasoline sector, India imports to the tune of 85%, meaning a drop cut in output or decimal increase in the prices will hamper the “D” line, i.e.:
- 1. Deficit (Trade and Current Account Deficits)
- 2. Rupee Depreciation
- 3. Depletion of Foreign Reserves
- 4. Gross Domestic Product (GDP Growth Dampening)
The reason being very obvious, we are a consumption based economy for Crude and not a producer based as against Agriculture where we enjoy the producer based advantages. This is a globally accepted phenomenon that whenever a country is dependent on another for any of its means, it is by default prone to the risk of the product availability or the price the country has to pay for that product.
Precisely in case of crude the impact is so large that a decimal variation impacts series of sectors starting from oil & gas to aviation to chemicals to automobile to logistics, etc. Strategic and economic ties with OPEC members and other Oil Giants also play a significant and substantial role in getting the giant tanker vessel which boards crude to the Indian coasts.
“What India has in its basket is a market fledged with enormous demand but no control over the factors catering that demand. And till then, whenever there is rise in the prices, the common man has to loosen his pocket, because going back to the stone age is not an option.”