Headlines from news sources across the financial industry rushed to proclaim “Oil Trading at Negative Prices” yesterday as the May contract for WTI (West Texas Intermediate) Crude Oil traded in negative territory. How can oil, a commodity with versatile uses, trade at negative prices? Would a company really pay to have its product taken away? It’s complicated.
The oil market is large and only one small part of it went negative. Oil commodities consist of the spot market (current market prices) and the futures market (prices for a future date). Yesterday’s negative price was only in the futures market. There are two main types of oil: WTI and Brent Crude. Only WTI went negative. Finally, futures extend far into the future. Only the May 2020 contract went negative. Let’s take a closer look at why.
A futures contract is a legally binding contract between a buyer and a seller to transact at an agreed upon price on a set date. A buyer who still owns a contract at the expiration date (which was yesterday for the May contract) is contractually obligated to buy the oil at the agreed price and take delivery of it. A buyer who does not do so is in default of the contract; the seller of the oil can sue.
In the futures market, most traders unwind their positions (sell if previously bought and buy if previously sold) prior to expiration because most participants don’t have the ability to take physical possession of large numbers of barrels of oil. Usually though, there are some oil companies who can take delivery and will buy if the price gets too low. That did not happen yesterday. With few people flying or driving, oil reserves are full. Nobody had the capacity to take the physical oil, so traders were forced to close out their positions at any price, even a negative price to avoid defaulting. It’s kind of like having an estate sale when moving. It would be better to get $100 for your dining room table, but if no buyer comes along, it still needs to go, and you might end up paying someone $50 to take it away.
How did this happen? In a properly functioning market, oil prices should not be negative because oil has use not only as a fuel but also as a key ingredient for countless products. There are two main types of crude prices: WTI and Brent Crude. Brent represents more of a worldwide price of crude since it is produced near a seaport and can be easily distributed globally. WTI is a landlocked crude, produced in the middle of America, and can only be delivered to Cushing, Oklahoma. Buyers of WTI must take possession of it in Cushing and then either store it or have a way to immediately ship it. This is where the breakdown occurred.
Financial markets are constantly rebalancing themselves and engaging in price discovery. When prices get too high, people sell, and the increased selling brings the price back to equilibrium. The same process happens in reverse when prices fall deeply below the economic value; buyers step in and bring the price back to its proper value. But when WTI prices fell yesterday, buyers did not step in. It seems like it would have been a perfect opportunity to make a significant amount of money by buying at negative prices and selling the next month at positive prices. However, to restate the key points, futures contracts are legally binding and delivery must be taken in Cushing, Oklahoma. If there is no available storage in the area, and no transport system in place, then nobody can buy. If nobody is buying, the sellers become desperate even to such a degree that they are willing to pay others to take the contract off their hands. That is what we saw yesterday in the May WTI Crude futures.
The other type of oil, Brent Crude, is still trading in the $20 range, and even WTI Crude futures for June is still $15 per barrel. The price for future WTI one year out is in the $30 range (see chart below). So, the negative price was an aberration in the current contract that expired with too many sellers and not enough storage capacity for the buyers. We joked about buying some oil yesterday and storing it at our vacant White Pine offices. Unfortunately, we couldn’t figure out how to transport the 1,000 barrels one futures contract represents up to our offices, and we’re not sure all the barrels would fit.
Last month, Russia and Saudi Arabia indicated there would be no slowdown in oil production, thus exacerbating the excess supply caused by the coronavirus pandemic halting the great majority of air travel, automobile use, cruise trips, and other economic activities that typically use oil. As always happens with a large supply and a dearth of demand, prices dropped. It is unlikely the world-wide Brent Crude price will go negative as there are still some places in the world to store the excess supply. However, if demand doesn’t pick up soon, it is possible we will see a repeat of this issue when the June futures contract expires.
While the impact to the overall equity market is minimal, this event does provide some insight into the health of the global economy. Oil prices and the economy often go hand in hand as oil is one of the main fuels used to generate energy. The low prices indicate the severe lack of demand both in the US and the world. This unusual phenomenon is a symptom of the severe disruptions we are all feeling in our daily lives. The futures curve may indicate how long the market thinks this lack of demand will last and when the economy can begin to return to normal; the graph indicates the price of oil returns to a more typical $30 price by the end of the year. We will continue to monitor this situation and how it affects our positions. Meanwhile, we’ll work on reconfiguring our desks to accommodate 1,000 barrels of oil.