West Texas Intermediate futures fiasco has lessons for Asia

The unprecedented collapse in US oil futures into negative territory has little direct relevance for the industry in Asia, but is vastly significant for the world’s biggest crude-importing region.

The immediate fallout from the dramatic plunge into negative pricing for the front-month West Texas Intermediate (WTI) futures was largely a result of the design of the contract.

The contract requires physical delivery to the storage hub at Cushing, Oklahoma, which is already nearly full. The contract dropped to as low as minus $40.32 a barrel on April 20, the day before expiry, as investors that were unable to secure physical storage had to exit positions at any cost.

Asia’s trading community views the dramatic swings in US oil prices in recent days as fascinating, but not really relevant.

That is because the vast majority of the crude traded in the region is priced off Brent futures, or a combination of the Dubai Mercantile Exchange’s (DME’s) Oman contract and Middle East assessments by price reporting agencies. While these benchmarks have dropped sharply, they are still fulfilling their price discovery functions.

It would be hard to argue that the market for crude in Asia is dysfunctional, even if prices are extremely low, and in the case of the DME contract, near the weakest since its 2007 launch.

The DME contract is physically settled, but delivery is at a port, and it is therefore unlikely to suffer from the same constraints as the landlocked delivery point for WTI.

But what the fiasco in WTI futures does show is that the crude market is capable of becoming disorderly and unruly in exceptional circumstances, and Asia’s traders would be wise to be cautious.

For instance, the deal to cut output by Opec and its allies, including Russia, by 9.7-million barrels per day (bpd) has largely passed by Asia, with exporting countries still appearing to compete hard on winning or keeping market share.

In the wake of the deal that was agreed on April 12, Saudi Arabia’s state-controlled oil company released its official selling prices for May, which raised prices for the US, kept them flat for Europe, but reduced them for Asia. Saudi

Aramco’s benchmark Arab Light grade was set at discount of $7.30 to the Oman/Dubai average for Asian refiners for May loading cargoes, a steeper discount than the $4.20 for April.

Many in the market see this as a sign that the Saudis are still planning on chasing market share in Asia, even in the face of weakening demand.

The Saudi move has also ensured that other Middle East producers kept oil prices low for Asia, as did Russia.

Demand cannot keep up with supply. The problem is that Asia’s refiners are starting to experience weak demand for fuels, especially petrol and jet paraffin, and are starting to cut back on output.

Only China is taking more crude, with Refinitiv Oil Research estimating that imports will total 10.42-million bpd, up from March’s 9.72million bpd.

Russia is set to supply more crude to China than Saudi Arabia for a second month in April, according to Refinitiv, perhaps underscoring that the rivalry between the world’s two biggest exporters is still ongoing.

However, it is outside China that the lesson of the WTI debacle is likely to become more acute for Asia. Already, much of the region’s storage capacity outside China is nearing capacity, as in India, or is booked and unavailable for new flows.

This means that many refiners in the region will have no option but to cut throughput and in turn reduce crude purchases, no matter how cheap oil eventually becomes.

If the suppliers of crude oil to Asia, led by Saudi Arabia and Russia, fail to cut back meaningfully on supplies, they will run the risk of a disorderly collapse in prices as they desperately try to sell crude that refiners can’t process or store.

With India, the region’s second-largest importer, still under lockdown and increasing problems in third-ranked Japan with containing the spread of the coronavirus, it is likely that Asia’s demand for crude imports will stagger in coming months.

China by itself will not be enough to hold up demand.

And even if other countries in the region do manage to start lifting lockdowns in coming weeks and months, the process will probably be uneven.

In that event, demand for crude oil will probably not recover as sharply as it has fallen.