Question

According to what you have learned from the International Equity Market and Derivative, why the price of oil future was negative on one day during the pandemic of COVID 19? Please explain using your knowledge of physical settlement of future contract.

Answer 1

Based on the theory of physical settlement of future contract, If an Oil company enters in to a future contract of say 6 months for 1 million barrel of oil, then after 6 months the company will have to physically deliver the oil to the future buyer as on that date.

Due to the COVID pandemic, the demand of oil has slumped significantly as most of the countries are in lockdown and hence are not using oil either for commercial purposes nor for the day to day use of the citizens.

In such case, in the near future they don't need oil or need a very meagre quantity of the same. At the same time Oil companies cannot stop their production of oil as it is a continuos production process. Thus, supply of Oil remains constant but demand has decreased to a level of none. Thus, in future the produced oil has no consumption and therefore no one is willing to buy them.

The oil companies need to store these already produced oil somewhere, and for that they have to incur cost. Thus, they don't have any revenue but they have cost of storage. This equation has made the oil price negative.