The oil price fell by more than 250% yesterday. Yes, you read that correctly. The oil price started the day at a bit below $20. By the end of the day, the price had turned negative. And it closed the trading day at -$37.63 (although at one point it went below -$40).
I know you’re fed up with the word “unprecedented” so I’ll just say: this has never ever happened before. (As if you needed to be told that). So let’s answer the obvious question first – what on earth is going on?
Why the price of oil (well, a specific type of oil) has turned negative
First things first – don’t get too excited.
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The oil price that matters is not negative. You and I will not be getting paid to fill up our cars when we finally get out from lockdown. This morning, Brent crude oil (the European benchmark) is trading at around $18 a barrel (which is down by a pretty hefty 20% or so, but not negative by any means).
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So which oil price are we talking about? I’ll come back to that in a moment. But first, let’s take a look at the “big picture” problem here, so we have a firm view on the background before we get to the technical stuff.
The core problem for the oil market is this: the coronavirus means that economic activity around the world has taken a massive hit. So we’ve seen an extraordinary plunge in demand for oil. Hardly any planes flying around, a lot fewer cars driving about – you can see the problem.
Meanwhile, the supply of oil hasn’t dropped by anywhere near as much as demand. In fact, until very recently, when they made a half-hearted deal to cut production, oil producers were hell bent on pumping as much as they could because of various attempts to stiff their competition (the Saudis and the Russians want to bankrupt each other and the US shale producers, basically).
So loads of oil is being pumped, but much less than usual is being used. What does that mean? It means you need somewhere to stick all that unused oil.
Now, as any MoneyWeek reader who owns physical gold will know, storing a “real” commodity costs money. You need a safe place to put it, you need insurance, you might even need to pay to move it from A to B.
And the thing is, gold isn’t a volatile, toxic substance that can only be safely handled by professionals. At the end of the day, you can bury gold in a hole in your back garden if you want to. Can’t do that with oil. Oil requires specialised storage. And there’s only so much of that to go around.
So that’s your overarching problem. We’ve got a lot more oil than anyone can use, and storage space for the spare oil is running out. Or to put it differently, you suddenly have a lot of demand for oil storage, and not enough supply.
But how did we end up with a negative oil price in this specific instance?
OK. Here’s where it gets a bit more fiddly, and I’m going to ask for forgiveness if I mangle or over-simplify this explanation (expert comment welcome at editor@moneyweek.com – put “Schoolboy error” in the subject line so I can spot it).
A beginners’ guide to the oil market
Let’s talk about how oil (and most other commodities) is traded.
When you buy shares on the stock exchange, you take ownership of the shares. You buy or sell via your stockbroker, and then through lots of backroom processes that you don’t usually need to worry about, ownership of said shares transfers from the previous owner to you. You buy the goods and you take delivery – even if it’s just a digital good.
Oil is different. Oil is mostly traded using futures contracts. These are agreements to buy (take delivery) or sell oil at a specific price on a specific date in the future. They “expire” on a monthly basis, at which point the party who owns the contract takes delivery from the party who wrote the contract.
The price of oil you’ll hear quoted in the news is generally the price of the “front month” contract – the one that’s most current. But there are lots of different contracts – for example, right now you can agree to take delivery of Brent crude at a price of around $30 a barrel at the end of September.
If you need physical oil – you run an airline or an oil refinery, say – then you can buy futures in order to lock in a price and have some certainty about your costs. But some people just want to bet on the oil price. They don’t ever want to take physical delivery of the oil itself, they just want exposure to its ups and downs.
So at the end of the month, these people would normally just sell the contract that’s about to expire, and buy the next month’s (they “roll over” the contract).
So that’s a very rough explanation of the futures market. (We’ll park the terms “contango” and “backwardation” for now).
There’s another point to highlight. As we briefly noted above, oil comes in lots of different types – it’s not a universal market like gold, say. So when we talk about the oil price, we usually mean the European/international benchmark (Brent) or the US benchmark (West Texas Intermediate or WTI – the one that turned negative). There are key differences between these, which help to explain why WTI crashed so hard.
So here’s what happened yesterday. The May contract for WTI was due to expire today, whereas Brent was already on the June contract. That’s the first issue. It meant that anyone holding the WTI May contract either needed to be ready to take delivery of the oil, or needed to sell the contract to someone who was willing and able to do so.
This is where the differences between Brent and WTI come into play. Brent is a “seaborne crude” as the Financial Times puts it. If you are short of storage space, then you can rent a big oil tanker, and just leave it floating around. You then profit by selling the oil further down the line.
Yes, I know that sounds drastic – it’s not exactly hailing an Uber – but it can be very profitable, as long as you can get a tanker at the right price. Of course, because there’s a shortage of places to store oil, it means that the cost of renting a supertanker is going up, which is great for companies who own the supertankers in the first place. But that’s another story for another day.
The problem with WTI is that it’s inland and there’s only one place to deliver it – the oil hub of Cushing in Oklahoma. And storage in Cushing is full – or at least, any spare capacity has already been rented out.
So, long story short – if you held a May contract for taking delivery of WTI oil and you had nowhere to put it, you were stuffed. So if you wanted to get that contract off your hands, you had to pay someone to take it, in some cases as much as $40. And if you then wanted to roll over into the June contract, that would have cost you $20.
So you made a loss of $60 to roll over your bet on crude oil. Most of the time that rollover cost would be a couple of dollars tops. In other words, it would have been an absolutely catastrophic trade for anyone on the wrong end of it. This is why some people think we’ll hear about hedge funds or other players going bust in the next few days (though that depends on whether or not America’s central bank, the Federal Reserve, has already stepped in to save them).
Hang on to oil stocks but be prepared for a rough ride
So what does all of this mean? Firstly, it’s a valuable reminder that you shouldn’t invest in anything you don’t entirely understand because if you get caught unawares the consequences can be much nastier than you expected.
Secondly, it points to just how spectacular the disruption in the oil market currently is. On the one hand, the oil price hasn’t actually gone negative. What actually happened is that the price of a specific type of oil, due to be delivered to a specific geography, on a specific date, turned negative.
But the fact that this happened at all points to the weird territory that we’re in. And the aftershocks are looking pretty brutal this morning. Both Brent and WTI are sliding hard – Brent is down about 23% as I write.
That’ll be because, as Louis Vincent-Gave points out in Gavekal, the obvious question now is: why wouldn’t the same thing happen again next month? After all, production has not collapsed and storage capacity is not going to suddenly rocket in a month.
And a third thing is clear – the resurgence in the oil price that we saw after the much-heralded deal between the US, Saudi Arabia and Russia to remove production from the market has been well and truly hammered.
I’d still hang on to your oil majors – they are cheap, and this kind of oil market havoc is only going to bring the point at which production really does collapse much, much closer. But be prepared for a rough ride.
We’ve already run on for too long today but there are plenty of other consequences from all this, as well as interesting potential opportunities. I’ll look at those later in the week. We’ll also be picking up on the story in MoneyWeek magazine in the next few weeks – subscribe now to get your first six issues absolutely free.
