April 20, 2020 will go down in the history books. For the first time ever, American oil also known as West Texas Intermediate (WTI) traded at a negative price, reaching lows of less than -$40 a barrel. A few people have emailed me asking as to the reason why this has happened. So I have decided to dedicate a post on the topic.
To understand how oil prices became negative one needs to understand futures trading/contracts.
A futures contract is a contract to buy something in the future. It is a contract to buying something at a set price at a predetermined time in the future. You can lock in a price now for delivery later down the line. When you buy most commodity contracts e.g. for oil or corn or coffee, you actually buy the “physical” product at a future delivery date.
Say you have a futures coffee contract. If you don’t close out your coffee contract, you get a call from the exchange telling you that your/coffee is ready and waiting for you.
Same with oil. Tankers will show up in Houston or Oklahoma with millions of gallons of oil and somebody needs to take the delivery. The problem in the US is that all the storage is currently full. Thus, nobody can take this oil as there is nowhere to store it. So people that bought these future contracts (in the hope they would be able to sell them at profit) are literally paying $40 a barrel to get rid of the oil. They are paying $40 and giving away oil so that it becomes someone else’s storage problem.
This whole negative oil prices resulted form the way oil futures operate.Normally traders sell their futures before the end of the contract to avoid oil turning up at their office. But on April 20, they found they couldn’t sell their futures as no one was willing to buy. As per Bloomberg ‘Contracts for May delivery were due to expire on April 21, putting maximum pressure the day before on traders whose contracts were coming due. For them, selling at a steeply negative price was better than taking delivery of actual oil because nobody needs it and there are fewer and fewer places to put it.’
In terms of storage, most places have reached maximum capacity. The coronavirus outbreak has left the majority of the population in lockdown. We’re not driving, factories are temporarily closed, and we’re simply not consuming as much. Lower demand for energy means a lower demand for oil.
So why haven’t oil producers stopped producing oil?
That is a really good question and to answer it one needs to understand the economics of the oil industry. For many oil producers, it is simply economically unviable to shut production. It is cheaper in the long run to keep pumping oil than closing down production or finding a place to store the supply bubbling out of the ground. Many producers worry that by shutting their wells might damage them permanently, rendering them uneconomical in the future
So it’s currently rough out there. It will be interesting to see what happens to the June and July contracts. If these turn negative, all hell will break loose.