Question

In: Economics

Due to the pandemic of COVID-19 in the U.S., the price of U.S. crude oil contracts...

Due to the pandemic of COVID-19 in the U.S., the price of U.S. crude oil contracts for May 2020 delivery has turned negative for the first time in history. For instance, West Texas Intermediate (WTI) crude oil contracts for May fell 301.97 percent to -$36.90 per barrel.
State your understanding of this phenomenon and carefully explain your arguments with economic tools and/or economic intuition, including the aspects of
1.   demand for oil by households;
2.   demand for oil by non-household demanders, such as manufacturers;
3.   market supply of oil;
4.   equilibrium price and quantity.

Solutions

Expert Solution

While there is lower demand due to the virus and definitely lower demand results in lower prices, the prices going below zero is because of many aspects which are specific to the oil industry. First lets see the demand side.

It is clear that due to lockdown, the demand of oil by households completely crashed. When people are not driving, they are not going to buy oil.
The demand for manufacturers also went down because many factories were temporarily shut-down. There was also loss of demand in trucking due to lower amount of goods being transported.
The market supply of oil is a more specific issue with the industry. The industry, especially US shale oil industry, can't just turn their oil wells on and off. It is a very costly process, especially if done for a short period of time (which this Covid 19 crisis is expected to be). Also, the storage space for oil is also limited. Because most oil storages are already filled, no one is ready to buy the oil because there is no place to store. At the same time, the wells cant just be shut off for a few days. So for contrats of May, the manufacturers were actually ready to pay the buyer because effectively they were paying for the storage and to make sure that their wells are not shut off.

This brings us back to demand and supply. Not only in this case there is no demand and excess supply, but the costs associated with supply are such that making supply zero has even higher costs! Hence, this resulted in the prices of WTI becoming negative.


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