This week, the market showed something that had never happened in history. Oil Prices (CRUDE OIL) in the U.S. fell below $0, -$37 / barrel as of now. How can price, something that we pay to get something in return, fall below zero? Does a negative price mean the sellers are paying us in return when we buy goods from them? These are all valid questions, and to understand what is happening points us to Economics-101. Price.

First, we need to understand how Price works in a ‘free market’. Price is an intrinsic parameter that floats on the huge vicinity of the market and is responsive to many factors. For now, just to understand how prices work, we are going to take into account two major parameters: Supply, and Demand. Here’s a basic graph showing how a commodity is priced in a market.

Basically the price of a commodity in a market is determined when the demand curve meets the supply curve, somewhere. That is, people wish to have more demand when the prices are low and people wish to supply more when the prices are high. The free market price is always controlled by scarcity. For example, if there are enough eggs supplied to the market and there doesn’t exist as much demand, then the price would automatically come down to make customers buy the eggs, because as we know if the prices are low, the demand seems to increase. And then when the supply is adjusted as per the demand, the prices regulate itself accordingly, in-par to how much the customer wants to pay. This is how prices are set (remember we are keeping all other factors constant).

Things are a little bit different in the case of oil prices. First of all, the prices in the oil industries are set in reference to the future. ‘Future contract’ is a tool that allows investors to bet on the prices of oil in the future by speculating the market. It basically means that suppliers of crude oil contractually agree in the present to deliver an agreed amount of crude oil in the future. So, the crude oil suppliers should pump out oil in their wells in reference to the future. And now enters the supply-demand framework hit severely by the pandemic, COVID-19. As we are very much aware of how the world is halted, businesses are shut and transportation is close to null, the demands for oil as of now is near to zero (as compared to normal times). But the pumps have been pumping on (for future contracts), to control the supply by immediately slowing down the pumps is not technically feasible. Also there is a significant role played by OPEC (Organization of the Petroleum Exporting Countries), a topic for a different day. So we are now clear on the fact there exists a huge crater of incongruity between the supply and demand of crude oil.

Now for the buyers to buy the crude oil is a technical problem. Since the demand is very low they ought to store the oil that is to be brought in the future as per their contracts, remember. So, they are being sold out to those who own storage spaces for oil. People are actually giving out crude oil (contracts) and paying the buyers to take the oil away. THERE’S NO STORAGE. This takes us to the question, ‘If oil price dropped below $0, why aren’t we getting gas for free? Its gasoline we use for vehicles and price that went collapsing was of crude oil, so the production cost for the refineries and distribution infrastructure costs add up to the price we are paying right now which is also exceptionally low.

For now the prices seem to be toppling down and are predicted to go down even more as the shut down of the world continues. But, there is interesting speculation of the extreme price hike of oil in the near future. Because, when the world re-opens, the demand would increase in a flash, but with suppliers that went bankrupt today, and the ones who slowed the supplies just to exist in the market will not be able to meet the demand. So, the market would automatically readjust the price high enough to distribute the oil as per market requirements. Oh the wonders of free-market!!