How does Oil get to a negative price?
Updated: Jul 3, 2020
This past week, we’ve seen a historical event in the market. A couple of week’s ago analysts were predicting $10 oil which would have been unprecedented. And those analysts were wrong, but not in the way many might have imagined. This week, crude oil price actually fell to a shocking -$37 per barrel. In this week’s post we will look at how such a phenomenon is possible, what does it mean for the rest of the stock market and what opportunities are available to invest in.
To understand the crude oil price that has been the main topic of business news in the last week, we first need to understand what a futures contract is. When you click crude oil prices on any finance app, you will see something like this:
Do you notice the month beside the Crude Oil title? That represents the price of the commodity futures for that specific month.
A futures contract basically means the holder of the contract MUST buy/sell the oil at a future time. So if we were to buy crude oil based on the screenshot above, we would be paying $17.18 for a barrel of oil that will be delivered to us in June 2020. You do not have to buy a futures contract 1 month out, there are contracts that are available many years into the future. Suppose you are trading a contract in January 2025, you are basically speculating what the price will be at that point in time. As you get closer to the contract date, you can then sell away that contract to someone else, and if you have speculated correctly, the contract will earn you a profit. But the key idea is that the oil is physically delivered.
The oil contract that went to -$37 in May was the Nymex WTI Crude Oil Futures (CL) and this contract is a physically delivered contract. While there are many other contracts that are also sold on a deliverable basis such as the Brent Crude contract, the WTI crude is special because the oil is delivered in Cushing, Oklahoma which is a landlocked area. While the facility does have storage options, they are currently full and so are the pipeline capacities that bring the oil away from Oklahoma. Generally, oil storage globally is at a shortage. It is different for the Brent Crude because the oil source is offshore and the receiver can charter and take delivery on a ship. So with no one being able to physically take delivery of the oil, the contract holders were actually paying to get rid of the contracts. And since very few have the capacity to take or store this oil, the price went lower and lower and crossed negative.
So what can I do to make money on this?
Firstly, if there was any opportunity, then the time to pounce on it has passed. June contracts have returned to normal (hopefully) as the major players have arranged for storage and transport.
There are storage and shipping company stocks that have skyrocketed in the last week due to shortage of oil storage and transport options. These are potential investment opportunities if you are predicting a similar phenomenon in the future then these 2 sectors would be a good play.
I was considering investing in Oil based ETFs until I learnt what they were actually doing. The most popular oil ETF, United States Oil Fund (USO) actually fell 35% in price last week. That’s because the ETF bets on oil on a rolling basis. They will buy the front month contract and then sell it just before expiry and buy the next months contracts. So oil price drilling in May has basically hit USO really hard. In the last few weeks, 2 other oil ETFS - iPath Series B S&P GSCI Crude Oil Total Return Index ETN (OIL) and ProShares UltraPro 3x Crude Oil ETF (OILU) have already liquidated and USO might be going the same way. Therefore these oil ETFs that deal with futures contracts are in big trouble.
In short, if you did not see this coming then there is basically no opportunity to profit from this and the oil ETFs are out of the question because in the current market, they are falling like dominoes.
If you are curious as to how these futures contracts work and the nature of the delivery here are some links:
CL Contract Specifications: https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude_contractSpecs_futures.html
CL Delivery Specifications: https://www.cmegroup.com/content/dam/cmegroup/rulebook/NYMEX/2/200.pdf
Disclaimer: This post should not be interpreted as investment advice as I am not a professional financial consultant. The objective of this blog is to share my experiences with others and receive feedback. I will provide links to my information sources to the best of my abilities, but the reader is responsible for their own due diligence