Causes and Implications of the Sharp Drop in Crude Oil - Mr. Tetsuo Inoue

Trend 1025: Implication 1 of WTI May contract at minus $37.63 per barrel

Yesterday I described the level of the Nikkei’s three-dispersion total, and last week the 25-day moving average deviation reached 6.441%, triggering a technical alert; but last night the Dow fell by nearly 600 points. In terms of the daily drop, honestly I have the impression that “it’s fortunate it wasn’t worse. Other indices didn’t swing as much as the Dow,” but what I originally planned to write today was that, as of the end of last week, the Dow’s 25-day moving average deviation was +10.75%, as noted in yesterday’s “Sign.” It was an extraordinarily high level, and you should remember that first.

Last night’s stock market decline was caused by an unprecedented “negative price” in crude futures, and this fact carries many implications.

First, the trigger was that today, 4/21, is the final trading day for the May contract, and there was an urgent situation where positions had to be liquidated rather than merely settled. Consequently, the drop in the June contract was not as large as for the May (near-month) contract, though it did fall, and it settled at $20.43 per barrel (down $4.60 from last Friday).

The “urgent situation that must be settled” arises because commodity trading involves “physical delivery plus funds.” Surprisingly, it is not widely known, but in WTI futures, the physical delivery of crude occurs in Oklahoma. If last night’s close was -$37.63 per barrel and tonight’s trading ends, for example, a buyer of 1000 barrels would receive “1000 barrels of crude plus $37,630 (about 4 million yen)” on the delivery date, while the corresponding seller (the long with a position) would have to pay $37,630 (about 4 million yen) to deliver the crude on the delivery date.

At first glance it might seem advantageous to the longs, but that is entirely not the case. Behind such abnormal delivery is the fact that the longs who have “received” the crude cannot simply discard it at sea; it must be stored somewhere, and the storage costs would be far more than $37,630 (about 4 million yen). Therefore, the longs rushed to liquidate, leading to this unprecedented negative price since the market’s inception.

Trend 1026: Implication 2 of the Crude Oil Plunge

Continuing to discuss the crude market from yesterday, last night the June contract, which became the near-month from today, finished trading at $11.57 per barrel (down $8.86 from the previous day). There were moments when it dropped as low as $6.50.

The reason for the negative price discussed yesterday was “storage.” According to the U.S. Energy Information Administration (EIA) weekly petroleum status report, inventories have risen for 12 consecutive weeks as of last week’s report (the 15th), with the most recent release (for the week ending 4/10) at 19.2 million barrels, the largest weekly increase on record. Moreover, excluding strategic reserves, U.S. crude oil inventories have surpassed 500 million barrels. In just the last three weeks, more than 50 million barrels—about 10% of that total—have been added.

Given the current level of U.S. economic activity, inventory reduction will take considerable time, and it is natural to expect that prices will not recover until U.S. production is reduced. However, production cannot stop completely: once production facilities (rigs) are shut down, restarting incurs large costs, so it is economically better to continue production, even at reduced volumes, to minimize losses. In any case, the maximum US crude storage capacity is said to be 650 million barrels. Tonight’s numbers as of 4/17 will show how far they have changed from last week’s 500 million, and depending on the figures there may even be a need to store crude on floating offshore tankers (ridiculously overpriced).

Currently, the price of WTI is effectively determined not only by the “expected price of crude” but also by subtracting storage costs from it. Consequently, negative prices, while seemingly unrealistic, are theoretically plausible. As long as the commodity remains under a “delivery against payment” system…

Now, regarding the Dow’s 25-day deviation exceeding 10% (10.75%) as of last Friday: the last time this occurred was during the rebound from the Lehman shock’s low on 09/03/26, in March 2009. The level of brightness or optimism then versus now is clearly different. Therefore, the overheated sense of the Dow as of last Friday was excessive, and while the recent two-day drop is attributed to the crude oil price, there is no inconsistency.