Why Oil Price Crashed Below $0 Per Barrel

First of all, there are Different Brands of Crude Oil

To start, it is worthy to note that there are different variants of crude oil in the international market with the Brent serving as the benchmark just the same way the United States dollar is the benchmark when converting different currencies of the world.

The Brent Crude oil is therefore a variant of the United Kingdom which is mostly used in Europe, and serves as crude oil whenever the term “crude oil” or “oil” is mentioned. Therefore, whenever oil is mentioned, Brent comes to mind as it is the benchmark just like the dollars in the currency market. There are however other variants of crude oil in the international market. For example, there is West Texas Intermediate (WTI) which is the oil produced in the United States (Texas in particular). Different countries have their own unique oil which they produce and the oil are different in terms of texture, taste, weight, etc.

Nigeria has three brands of crude oil and they are bonny light, Brass river and Qua Iboe. Bonny light is named after the city of “Bonny” and it is produced in the Niger Delta Basin. Brass river is named after one of the branches of Nun River which is also a branch of Niger delta, and produced in Niger delta, and Qua Iboe is produced at Akwa Ibom. So, it was WTI that crashed to -$37 per barrel, not Brent, not Bonny Light or any other kind of crude oil.

How the Forwards Market Works

Forward is an agreement to take delivery of some goods at a specific place and time while payment is made now or agreed to be made in the future. To get the concept, let us take an example of Mr. Mustapha the Farmer. Mustapha is a farmer who wants to produce 1000 bags of corn but is afraid he might not get a buyer by the time the harvest period reaches. So he contacted Alhaji Zai to enter into a contract with him. They both agreed that Zai will pay Mustapha 50 naira per bag of corn while Mustapha will supply Zai 1000 bags of corn once he harvests his corn. So Zai pays Mustapha N50,000 today (N50 multiplied by 1000 bags of corn). Let us assume that when the harvest period reaches, the market price for a bag of corn was N100, it means Zai has gained as he will be able to sell each bag at a price higher than he bought it in the forward market (when he had agreement with Mustapha). However, if the market price of a bag of corn at the time of harvest was N25, it means Mustapha the farmer gains as he already sold it N50 naira.

The scenario is a typical example of how the forwards markets work. You enter into an agreement today based on what the future price will look like. And this is how the oil forwards market also works.

Real Reason WTI Fell

The oil market works in a demand-supply way such that when there is excess supply, prices fall and when there is excess demand, prices rise. No thanks to COVID-19, demand for crude oil has falling by about 29 million barrels per day while oil producers have only announced supply cut of approximately 10 million barrels per day, which means there is still a glut of about 20 million barrels per day. And one peculiar feature of oil production is that once you have start producing, it will be very hard to stop production because your machines must be kept at certain temperature to be able to function properly and it is with crude oil extraction that the temperature is held very well. Hence if you stop production, the machines might be damaged beyond repair and it leads to twin problem of machine failure and not producing.

Based on the above, producers kept producing (with a cut to start from May) and since demand is low, it means producers are producing and storing. But there is a limit to storage- It gets filled up. At this point, do not forget there are traders in the forwards market.

There are traders that have had forward agreement in the past (say December 2019) that a supplier will deliver certain barrels of oil to them (the traders by May). The contract expires today (Tuesday 21 April) which means they must take delivery of the barrels of oil whether they like it or not. This is where the problem then lies as there is all storage capacities are filled up. Since the suppliers too want to offload, then it gets hard to want to defer the contract to a later date. Hence, there is no choice for you as a trader than to just sell at whatever price.

It then became a problem of too much suppliers (traders) chasing fewer buyers. Do not forget there is no storage and the suppliers too are already calling the traders to take delivery for their goods (oil) for which Today (Tuesday April 21) is the last day. Hence, a trader has two problems:

  1. He cannot defer the contract to a later date because even the suppliers do not have storage to keep. So both traders and suppliers are in the storage dilemma.
  2. The trader cannot just abandon the barrels of oil to the suppliers because even the suppliers want to offload.

The available option is therefore to offer to pay the buyers money so that they (the buyers) can take the barrels of oil off the traders’ hands. This therefore led WTI to drop by more than 300% to a negative figure of -$37 per barrel. Which means if you as a buyer wants to buy WTI, the trader will give you $37 for every barrel of oil you buy. If you buy 1,000 barrels, you will be given $37,000 as an incentive. It makes sense if you look at it. But if you take another critical look at it, it does not pay. For instance, 1,000 barrels of oil is said to be equivalent of an average Olympic sized swimming pool. Given the storage situation, it will be hard to get such except you are a “Dangote”. When you also consider the transportation and storage cost, one might end up losing at the end of the whole deal.

Will this Last?

At the moment, June and July forwards are still trading between $22 and $24 per barrel which shows the amount traders feel a barrel will cost at those months. Hence, spot price of WTI is expected to rebound later today as traders will now be focused on June deliverables. However, $20/barrel is still not a price oil companies will survive with for a long time. Therefore, if demand remains the same or falls below this level while storage capacity overwhelms, I expect what happened on Monday April 20 to still happen in May/June and Texas producers will be forced to leave the market.

How Does this Affect Nigeria?

The situation with WTI does not affect Nigeria but it presents a background of what is happening in the oil market. Nigeria does not sell WTI, hence the recent shock in WTI price is not expected to affect Nigeria. As at the time of writing this article, price of Brent (the oil benchmark) was $25.74 per barrel while Bonny Light was $20.88 per barrel (20 hours delay). Brass river and Qua Iboe are both trading at $22.75 per barrel according to the data obtained from OilPrice. Comparing that with the revised budget estimate of $30 per barrel, it means Nigeria is still losing as the current market price is less than the budgeted price. Hence, the revised oil revenue estimates still look over-optimistic based on the current market dynamics.

For questions, opinions, corrections and contributions, please drop them in the comment section. You can as well contact the writer on Twitter @K2ice_JR

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      • Ahmad Temitope

        Since it almost every nation demand has dropped compare to the pre-covid19 time.
        So overtime, if this Covid-19 issue isn’t resolved early, we should be expecting same situation going on with WTI to happen to Brent too? Which will definitely has impact on Nigeria crude oil too.

        • Abdulazeez Kuranga

          Brent is currently trading at $20.30 per barrel while it closed at $25.07 per barrel yesterday. So, if the current situation persists, then I believe Brent will also fall. However, I still believe countries will begin embarking on voluntary cuts to augment the agreed cut of 9.7 million barrels per day. So the cut is expected to be more that the agreed cut.

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