April 27 2020 Market Update
Why Would Oil Go Below Zero?
After seeing the price of oil fall below zero for the first time in history, people are understandably confused. How can this happen, and what does it mean?
First, it’s important to clarify that the negative price was for a futures contract expiring: namely, it was the contract for West Texas Intermediate (WTI) crude oil for delivery in May.[1] People trade oil futures because very few people actually want to buy barrels of oil. Traders generally “roll over contracts,” meaning they sell expiring contracts in order to buy longer-dated ones. That way, they can have exposure to fluctuations in the price of oil without ever having to own or take physical delivery of oil.
The last date to buy and sell the WTI contract for May delivery was Tuesday, April 21st, which sent traders into a little bit of a frenzy on Monday, April 20th, for two key reasons:[2]
First, economic activity has ground to a halt worldwide. The demand for oil has fallen precipitously – specifically, by about a third over the course of this year. When no one’s demanding oil, the value of it drops.
Second, producers are still pulling oil out of the ground. This means supply is still high – and since demand has fallen, producers, refiners, and anyone else who would normally be interested in cheap oil are starting to run low on space to store all that excess supply.
These two factors were so significant that for a moment there you would have had to pay someone to take delivery of your oil in May – that’s what a negative price implies.
Of course, prices bounced back up once the June delivery contract became the only game in town. In fact, between Wednesday and Thursday this week, the price of oil jumped 40 percent.[3]
That said, oil prices are still far lower today than they were at the beginning of the year, having fallen by about 75 percent in 2020.[4] The pandemic is partly to blame, as is the eruption of a price and supply war between Russia and Saudi Arabia.
We could see this happen again with the June WTI contract, which expires on May 19. This situation depends on whether producers start to ramp down production and economic activity starts to pick up – if they don’t, we could run into the same supply and demand issues.
Of course, most of us aren’t significantly affected by the price of oil outside of filling up our gas tanks. However, this situation does underscore just how unprecedented an economic situation this has been.
We’re facing a number of truly unique events across the economy outside of oil markets, including a spike in unemployment and historic levels of fiscal and monetary stimulus. While markets have recovered this month (as of this writing, the S&P 500 is up about 14 percent for April), we do think it would be prudent to prepare for some degree of volatility in the coming months. This is simply a situation without any real precedent, and as we know the “animal spirits” of the market can run high during times of uncertainty.
If you have any questions about the news or about your portfolio, please reach out to us. We are on call and working hard to support you in navigating this complicated time.
JSF Financial
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West Texas Intermediate (WTI): WTI is a crude oil that serves as one of the main global oil benchmarks. It is sourced primarily from Texas and is one of the highest quality oils in the world, which is easy to refine. WTI is the underlying commodity for the New York Mercantile Exchange’s (NYMEX) oil futures contract
Futures Contract: A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date. Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Sources:
[1] This article provides a useful overview of the situation: https://www.forbes.com/sites/sarahhansen/2020/04/21/heres-what-negative-oil-prices-really-mean/#5ec2bfd5a85d
[3] https://www.cnbc.com/2020/04/23/oil-news-crude-wti-prices-today.html
[4] https://www.cnbc.com/2020/04/23/oil-news-crude-wti-prices-today.html
