The crude oil price closed negative to -$37.63 per barrel on West Texas Intermediate (WTI) on 20th March, 2020. But you might be wondering how oil prices can be negative? The falling oil prices were not a surprise after the COVID-19 impact. There has been a sharp decrease in the consumption of the oil after the lockdown. The production war in the OPEC countries resulted in an imbalance in the demand-supply cycle which led to negative oil prices. The article explains the functioning of oil markets and impact of negative oil prices on the stock market in detail.
What is crude oil?
The crude oil is the non-renewable that is resource extracted from the Earth. It is converted into products such as gasoline, diesel, fuel, and other petroleum products. Since it is a nonrenewable and it is consumed at a higher level than its replenishment level.
How does the oil market works?
The oil market works in the same way as the stock market functions. Before that we need to understand the options of oil trading. So let us understand what are oil futures?
Oil futures are contracts in which the oil is traded at a set amount of quantity for a set price at the set time. The trading happens on futures exchanges and is a common method of buying and selling oil. The trader has to take delivery of the oil once the contract expires. He can nullify the contract only with a buy trade. Oil futures are just traded like shares but in the form of oil benchmarks. The two most popular oil benchmarks are Brent Crude and West Texas Intermediate (WTI). They are traded on the Intercontinental Exchange (ICE) and New York Mercantile Exchange (NYMEX).
There is another type of oil trading- Oil Options. Oil options provides you the right to buy a set amount of oil before a set date at a set price with no obligation to trade. You can trade without the compulsion of taking the delivery itself.
The traders prefer oil options to protect themselves from the adverse effects of the volatility in oil prices. Instead of storing, buying, and selling the oil, the traders prefer the future contracts and sell it before the contract expires. The traders take advantage of the price movement of the oil prices.
How crude oil price affect the stock market?
The crude oil is an important factor because India is one of the largest importers of oil in the world. Since India is an importer, the fluctuations in crude oil price is going to affect the economy and the stock market. There is an indirect effect of the price fluctuations in oil on the stock market. It is difficult to calculate the intensity of the effect.
The main factors which describe the impact of crude oil price on the stock market are:
Import of oil
India is one of the largest importers of oil in the world. So, the fluctuations in crude oil price is going to have an impact on the economy as a whole, and the GDP of the country.
Cost of production
The industries which use crude oil as raw material for the purpose of production will face an increase in the cost of the production. This will lead to increased prices of goods and laborers wage cuts. This will impact the stock prices of these companies.
Inflation (Cost of living)
The increase in crude oil prices will cause Inflation. Because the consumers will have to pay more for the transportation cost. They will spend less on consumer goods & luxury items such as electronics, clothing, etc. The decreased demand will affect the stocks of these companies.
India imports almost 3/4th of its oil needs making it one of the largest importer. The rise in oil prices will lead to an increase in the cost of imports and thus impacting the Current Account Deficit. In simpler terms, we have to pay more money to buy the same product. This will decrease the value of the rupee and thus causing rupee depreciation. When the rupee depreciates, it attracts more foreign direct investments in the country. On the other hand, the fall in crude oil prices will lead to rupee appreciation.
Thus the oil prices have an indirect impact but a significant impact on the stock market
Why crude oil prices are falling?
The crude oil demand has fallen due to lockdown in many countries. 90% of the world is under lockdown due to Covid-19 pandemic. But there was a price war in OPEC countries. They didn’t stop the production of the oil despite the lockdown. The demand has been falling but the supply of the oil was excess. In overnight trade, May futures for US crude oil WTI fell to minus $37.63 a barrel level. As on 22nd April, 2020 the May futures were going to expire and the buyers had to take delivery of the oil barrel.
The traders buy and sell oil in the market & take advantage of the fluctuations in the price movement. So the buyers have purchased the barrel but due to less demand they had to take delivery of the oil. They didn’t have the storage to store the oil. So they got into a panic and started selling. The price went down due to panic selling. The reason for the absolute collapse of prices was primarily due to the expiration of May contracts.
The future of crude oil prices depends on how long the lockdown extends. And it will take some time in the price recovery as long as the balance is established in the demand-supply cycle.
What does the oil market crash indicates?
The oil crash indicates the beginning of the recession that the world is going to face after the lockdown. It is an indicator of the economic slowdown. Abheek Barua in an interview with Economic Times said that he would call it as global recession with some of the European countries showing negative growth, the US may be growing in the range of 1-2 percent and overall global growth at about 2 percent, China at 3 percent that’s the kind of scenario we are in …crash in oil is in anticipation of a huge global recession that is being priced in,” said Abheek Barua, Chief Economist at HDFC Bank.
You can also read about the impact of Covid-19 on the stock market in our blog section.
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