On April 20, WTI crude oil futures at NYMEX plunged into the red. This made the MCX Clearing Corporation settle traders holding April contracts of MCX crude oil futures at minus ₹2,884/barrel on expiry day, April 20. This shocked the traders who were long on the contract.

Given that the negative price in WTI crude oil looks likely in the current month contract too, it makes sense to know the nitty-gritties of the MCX Crude Oil futures contract and the price equation between WTI and Brent Crude if you are a commodity trader.

Underlying is WTI Crude

The underlying for MCX Crude Oil futures is WTI Crude and not Brent Crude.

It is important to know that WTI Crude and Brent Crude are two different grades of Crude Oil. West Texas Intermediate (WTI) Crude Oil is extracted from oil fields in the United States ― primarily in Texas, Louisiana and North Dakota. Brent Crude is extracted from oil fields in North Sea. While Brent is the benchmark for oil coming out of the Middle East, Africa and Europe, WTI is the benchmark for oil coming from the US. The difference between the two oils also comes from their properties: Sulfur content (oil that contains less than 0.5 per cent sulfur is referred to as ‘sweet crude’) in Brent Crude is 0.37 per cent and its API gravity is 38.06 degrees. API gravity is the measure that compares how light or heavy a crude oil is in relation to water. Higher the API gravity, the less dense it is. The sulfur content in WTI crude is 0.24 per cent and its API gravity is 39.6 degrees.

Settlement is based on NYMEX WTI Crude futures

The MCX contract is cash settled based on the price of the front month futures contract of WTI Crude at NYMEX in the US. Front month means ‘near’ or spot month contract.

You need to note that for WTI Crude Oil futures at NYMEX, deliveries are finalised a month in advance. Thus, always, at NYMEX, the near month contract in WTI Crude futures contract will be one month ahead. For instance, in April, the near month contract was of May and in May it will be of June and so on.

So, traders in MCX Crude Oil futures for April were settled based on the price of the May month futures of WTI Crude futures at NYMEX. Also, important to note is that the NYMEX WTI Crude futures contract expires one day after the expiry of the MCX WTI Crude Oil contract. In April, while the MCX Crude Oil futures expiry was April 20, the NYMEX WTI Crude contract of May expired on April 21. Currently, at NYMEX the front month contract in WTI Crude is of June month ― the price of this contract will be used to settle the MCX Crude Oil futures of May.

WTI is at discount to Brent Crude

While by properties, WTI Crude is superior to Brent Crude (it can be refined into gasoline or diesel with relatively less processing), it trades at a discount to Brent. Studying the history, we see that before the US Shale revolution in the 2000s, WTI Crude commanded a $1-2/barrel premium to Brent Crude, but post that, the spread flattened out. In 2011, when US Shale Oil production started to surge and there were geopolitical tensions in the Arabian region, the price equation between the two oils changed. WTI lost its glimmer and Brent stood to gain: Brent moved almost $20-21/barrel higher to WTI Crude. In the following years as tensions in the Middle East eased and the US rig counts dropped in 2015, the spread between the two oils narrowed down, and by 2016 it was again $1-2/barrel. But this time, Brent was at a premium to WTI. In the last few years, the spread between the two oils has started to widen again, pushing WTI to a steeper discount to Brent. This is thanks to increasing WTI Crude output in the US and the storage constraints in Oklahoma. Currently, while WTI Crude futures in NYMEX is trading at $16/barrel, Brent Crude is at $21/barrel.

… but correlation between Brent-WTI still high

If your business is exposed to energy price risk, it still makes sense for you to hedge on MCX Crude futures contract that mirrors WTI Crude futures at NYMEX. Though the crude that India imports is closer to Brent, WTI crude futures still offer a good hedge as its correlation with Brent Crude is high. NSE and BSE both have crude futures contracts that are based on Brent Crude but these are not liquid. One thing you need to do if you are a hedger on the MCX Crude Oil futures is to make sure that you roll over to the next month contract or square up your position before expiry. If you leave it open, it runs the risk of being settled at zero or negative price. If you are keeping your crude oil futures position open on the expiry day, you are taking a wager on the storage capacity in Cushing. Do you want to really do that? This is effectively speculation and not hedging.

Negative prices may return

For NYMEX WTI Crude, the only delivery location is Cushing, Oklahoma. Given collapse in demand due to Covid-19 lockdown and with US shale oil producers not reducing their output significantly, there is going to be excess supply in the market at least for the next few months. With no increase in storage capacity at Cushing, at the end of every month, on the expiry day of the WTI Crude futures contract, there will be a problem. Note that unlike India, NYMEX crude futures contract in the US are settled only by delivery. So, when the buyer is not able to find storage till the last day of the contract, he will ask the seller to take it back and that will be for a price. Only if crude oil can be thrown on the roads or dumped in the sea, can a buyer get rid of his stock.

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