Neither David Ricardo nor Harold Hotelling would have dreamt of a world where the negative price of an exhaustible resource can prevail. Yet, it has already happened! On April 20, a sudden 300% plunge in WTI led to the negative price of minus $37.63 a barrel at the New York Mercantile Exchange (NYMEX), the global price discovery platform for crude oil.
Following the world
The situation has created rigmarole in market clearance across commodity derivatives markets of the world. In India, the Multi Commodity Exchange of India (MCX), which is the national level price discovery platform for crude oil, fixed the settlement price of their April futures contract at minus Rs 2884 per barrel. There are 11,522 open or unsettled positions that need to be settled on the expiry date of the derivatives contract. This leads to an estimated payout of Rs 435 crores on parts of those with long positions. Large brokerages are approaching the judiciary on grounds that assigning a negative settlement price is “… arbitrary and illogical and demonstrates an utter disregard of the basic principles and fundamentals of the settlement system in India”.
Negative price in the oil futures market is due to the apprehended “carrying cost” — one of the major components of the overall transaction costs. (Photo: Reuters)
Be that as it may, the Indian markets are simply following the signals of the global commodity markets. The regulations and norms remain in their domains and are not the central concern of this article. The concern is two-fold. The first is that prices realised in (derivatives) markets are often not reflections of the scarcity values of exhaustible resources, thereby reflecting on the inefficiency of the global commodity markets. The second is that negative price phenomenon is a dampener for the commodity economy, and thereby for the macroeconomy as a whole.
Let me come to my first concern. Exhaustible natural resources like crude oil follow simple linear consumption logic: greater burning up today implies lower availability tomorrow. Traditionally, right from the days of classical political economy, economists have followed this axiom. This was first observed in Ricardo’s work on the pricing of exhaustible resources, where he argued that the price of a non-renewable resource should increase over time. The Ricardian contention of rent created the basis for the scarcity value theory in natural resource economics. In 1931, Hotelling showed that even under conditions of efficient exploitation, a non-renewable resource would deplete over time, leading to an ever-increasing net price or “Hotelling rent”, reflecting on the increasing scarcity of the resource. In the 1970s, John Hartwick and then Robert Solow talked about investments in produced capital needed to off-set the declining stocks of exhaustible resources.
Hartwick’s idea was to invest the rent accrued from exhaustible resources to create a sufficient physical capital base. Some of the middle-eastern nations have more or less followed this principle and have invested in various other forms of capital so as to depend on alternate growth drivers in a “non-oil” world. But, even today, renewable energy sources definitely cannot replace fossil fuel that is getting scarce over time. Given this theoretical underpinning, why do we have a negative price for crude oil? At the very outset, it needs to be understood that the negative price has prevailed in the oil futures market largely due to the apprehended “carrying cost” that is one of the major components of the overall transaction costs. The global economy is under closure due to Covid-19! This has declined the demand for fossil fuel. Yet, the concern is that under efficient market conditions, the market-clearing prices should have been at worst zero, and not negative! An explanation of negative price is that the “carrying costs” that entail the inventory, interest and other storage costs are prohibitively higher than negative settlement prices and expected pay-offs (in the absolute sense) after the global economy resumes.
Reassess the market
In that sense, the price of crude is definitely not reflecting the scarcity value of the resource, which, by no means, can be negative. This is also due to market imperfections arising out of bounded rationality of agents (unable to foresee the future) and imperfect information. The speculative futures market phenomenon has thrived on apprehensions and myopia. This will have its bearings on the physical markets, as efficient futures markets are being viewed as the mirrors of their physical or spot counterparts.
Secondly, while a negative price is not a feasible phenomenon from an efficient market perspective, it is not desirable either. This is a clear dampener for the commodity economies and acts as a disincentive for the primary producers or owners in the commodity ecosystem. It sends a wrong signal on the state of availability of a resource, as also its potential use. This will lead to an adverse management regime of an exhaustible resource. Do we really intend to put the gross product value of the resource as negative on the basis of this price? From a factor income perspective, this leads to the values of the factors of production of the exhaustible resource as negative (think of a negative value of labour or other factors of production).
Further, a negative price defeats the purpose of valuation as well, as valuation plays important roles in resource allocation, raise awareness about the importance of the resource, or guide any form of legal proceedings for determining damages where a party is held liable for the loss to another party. Market regulators and participants need to keep in mind that the faith in unbridled market forces might be misleading at times, as markets are not always efficient!
(Courtesy of Mail Today)