How Negative Oil Futures Price Impacts Production

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A market shock, exemplified by the 1987 crash, denotes a sudden and severe disturbance in financial markets, leading to significant disruptions and abrupt changes in asset prices. This event can have a lasting impact. For instance, prior to the 1987 crash, volatility remained flat. Post the crash, there emerged a volatility skew.

Reference [1] investigated the causes and impact of the negative front-month oil futures price in May 2020. The authors demonstrated that the negative oil futures price was attributed to

  • A real physical constraint (lack of storage), but this constraint can be at least partly caused by non-physical financial traders who obscure the demand signal, and
  • Expiration of a futures contract when financial traders are forced to close their positions without taking physical delivery and the true demand is revealed.

Additionally, the authors also pointed out the impact of the negative futures price on oil production,

This event created a situation where a major oil price benchmark experienced a dislocation from the fundamentals affecting oil prices throughout most of the U.S., and we find that this channel led to real effects. Specifically, oil producing firms react to the elevated risk of a repeat event in May of 2020 by preemptively shutting a portion of their wells in anticipation of future dislocations of the benchmark, despite fundamentals outside of the benchmark delivery location being supported by ample storage availability. Once this risk has receded, firms resume normal operations.

In short, the fear of a repeat event prompted numerous producers, including those in regions not directly affected by storage capacity constraints, to temporarily halt production in May, even though prices had already rebounded to their early April levels.

This article offers additional compelling evidence regarding the impact of a financial shock.

Let us know what you think in the comments below or in the discussion forum.

References

[1]  Gilje, Erik and Ready, Robert C. and Roussanov, Nikolai L. and Taillard, Jérôme, When Benchmarks Fail: The Causes and Consequences of Negative Oil Prices (2023). https://ssrn.com/abstract=4666143

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