Questioning the Economic Rationality behind the US WTI price slipping into Negative Territory!!!
It was recently reported through all mass media platforms that WTI price, which is the US crude oil benchmark price (futures) slipped into negative territory. Ever since the news broke, I copiously challenge myself & other colleagues on the economic rationality behind a negative price for a physical commodity such as the US crude oil. My submissions are as follows:
From the demand side perspective, the economics of rational preferences as reflected in the transitivity property states that if an individual prefers commodity bundle B to commodity bundle A, and commodity bundle C to commodity bundle B, economic rationality dictates that the individual should prefer C to A. But some individuals would rather prefer A to C. Here is why??? Assume that we have just three oil producers in the US selling different grades of crude oil (A, B & C). Also assume that B is of higher grade than A, and consequently a buyer prefers B to A. Similarly, assume that C has a higher quality content relative to B, then economic rationality requires that the consumer prefers C to B. Ultimately, the transitivity property of preferences assumes that a rational consumer should prefer oil grade C to oil grade A. But it is also possible for the reverse case to occur in real life; here is why!
Given the subsisting oil supply glut on the US & global oil markets and the fact that the US oil producers are running out of storage space, let’s assume that oil traders sell their crude for free (implying a redistribution of welfare from sellers to buyers). Which of the two oil grades between A and C will the so-called rational consumer choose??? Someone would easily say oil grade C…but if say the seller of oil grade A offers prospective buyers $100pb while others settle for $30pb (According to Aljazeera News, oil traders being sceptical about tepid demand for their crude offered every prospective buyer $30 per barrel (pb) so as to evacuate excess supplies from their reach). Now, how do you evaluate the consumer's preference position??? A consumer that is suffering from poverty of economic rationality & ideas will prefer the oil type with lower grade (A) to C with high quality content just because he gets a net returns of $70pb by choosing oil grade A over oil grade C.
From the supply-side perspective, the Economics discipline teaches us that where there is excess supply of a product, producers or sellers will have to price down their products in order to find buyers. Meanwhile, the US oil traders are doing this indirectly by paying interested buyers per barrel of oil taken away from them. Is the approach of selling your products at zero price and paying off prospective buyers not counter intuitive??? In Economics, quantity supplied of a commodity (not services such as labour supply) is said to be positively related to its price. Here is why, in a perfectly competitive market where each seller faces a common price, if we tri-sect the U-shaped marginal cost curve into three portions – decreasing marginal cost (equivalent to rising marginal returns to a factor input); minimum (or turning) point on the MC curve (equivalent to a point on the short-run product curve where marginal returns to a factor input is at its peak) & the upward sloping portion of the MC curve (which equally mirrors the portion of the MC curve where the law of diminishing returns has started to set in). The question is on which portion of the MC curve should a producer or trader supply its products to the market???
An answer will be that for a profit maximizing firm operating under perfect competition, the supply curve it faces is that portion of the MC curve that is above the minimum average variable cost curve (which is to the right of the shut-down position of Price = Average Variable Cost = Rising portion of the MC curve). Let’s think through this…if the US oil producers are rational enough, they should give their crude for free & nothing else…or help ask if they are ready to lose their mark-up & start-up capital as well? This is not sustainable though. The good news is now that the market has returned to a positive price trajectory after the US President Donald Trump allayed the fears of investors in the US oil futures market that a number of policy pronouncements are likely in coming weeks. According to Aljazeera News, the US government is planning to extend financial aids to the so-called high cost oil producers, has promised to buy at least 75 million barrels to shore up the country’s strategic petroleum reserves & is considering plans to curb more oil shipments from Saudi Arabia into the US market.
###I rest my case here###
https://www.aljazeera.com/ajimpact/oil-prices-crash-affect-200421134650761.html
https://www.aljazeera.com/ajimpact/trump-calls-financial-lifeline-struggline-oil-industry-200421143445155.html
You can track the WTI price trajectory via: https://www.bloomberg.com/quote/CL1:COM
The price of oil is shaped by supply and demand. Due to the coroner's crisis, the demand for oil internationally has collapsed and with it the prices. Small and large businesses order less oil, airline fleets remain stuck on the ground and consumers stay home and do not use their vehicles.
These are the so-called May contracts, which expired on April 21. Which means that whoever owns such a contract that day, also owned the agreed amount of oil. However, oil reserves are high, so the cost of additional storage increases. For this reason, investors turned their backs on fixed-term contracts, which not only lost their value, but their prices fell to negative levels.
Speculators may be interested in time contracts because they are essentially betting on future price formation. They can therefore make or lose money. There are many speculators who have been lost these days. Many companies want to secure their transactions in the fossil fuel market so that they know in advance how much they will have to calculate. Only at this time no one wants oil, the delivery of which is guaranteed by the deadlines.
WTI (West Texas Intermediate) crude oil has limited storage capacity, as the pipelines end up in Oklahoma, where the world's largest storage facility is located in the city of Cushing. But there the spaces are already full and extra space costs about ten dollars per barrel. And it is not ruled out that their price will increase further. It should be noted that for the European type of Brent oil there are more storage possibilities.
Oil companies will face problems if prices remain so low. This could have an impact on loan service as well as employment. Low prices are pushing the sluggish production sector to the brink of bankruptcy. Observers estimate that these companies need a barrel of $ 50 to cover their costs.
Dear Wasiu Adekunle,
On commodity exchanges, some categories of commodities traded are mainly cyclical. For some categories of raw materials that are priced on commodity exchanges, market factors dominate. On the other hand, there are also raw materials, the prices of which on the international raw material markets are determined not only by market factors but also by other factors. Some categories of raw materials considered strategic for many sectors of the economy and in the context of international trade wars operate on regulated markets and / or subject to periodically intensifying speculative activities (e.g. in the event of international economic crises) globally operating financial institutions, including investment banks and funds investment. This type of strategic raw material is crude oil.
Greetings,
Dariusz Prokopowicz
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