NEGATIVE OIL PRICE – There's a first time for everything
Another domino falls in place. We have just witnessed negative oil prices. What? How is that even possible? Well, let me try to explain it.
First, before we went into the great lockdown of the Coronavirus, oil supply was at its high point. The U.S. producers and everybody else was pumping oil as if there was no tomorrow.
Then came the great lockdown, and it brought a sudden collapse in oil demand, after driving, flights, and maritime trade stopped for weeks. Some analysts estimate forecast a -20 MM barrels reduction per day of consumption.
As we were facing the unthinkable oil industry collapse, the OPEC countries and other non-OPEC producers, after a few squabbles, decided to establish another record, an oil production cut of 10MM barrels per day of production.
Even the U.S. producers, unwillingly, will have to cut, according to several sources, the Texas Rail Road Commission is considering to scale back oil production.
After all these efforts to defend oil prices, the production is so high vs. the demand, especially in the U.S., that the storage space available to keep excess oil, it is about to reach its limits in May.
So, what happens when all the tanks are filled up? Well, you start to reduce prices until you find a suitable buyer, or you may shut down oil production, or prices may go negative.
A little explanation is required to understand this first time that we experience a negative oil price phenomenon.
There is not a unique price for oil, as oil is not homogeneous. Every oil type has different physical and chemical characteristics. These oil qualities have value to a group of refiners who have adequate plant capabilities. Therefore, an oil producer's location and delivery point matter substantially for commodity pricing.
For example, the WTI or West Texas Intermediate oil, a U.S. oil production in Texas and delivered at Cushing, Oklahoma, has a unique market dynamics and prices. Moreover, there are several prices for WTI oil, the spot price, and the future prices for each delivery month.
Quoting from investopedia.com, "The spot price is the current quote for immediate purchase, payment, and delivery of a particular commodity. The futures price for a commodity is an offer for a financial transaction that will occur on a later date".
This future transaction means you accept the responsibility to provide or deliver a good to the other party on a specific date in the future, or in some cases, compensate the other party financially without physical delivery. This type of future instrument trades on contracts on monthly expiration that depend on an oil price benchmark like the WTI, but it is not the spot price of oil.
But today, April 20th, 2020, the future price of the WTI oil to be delivered on May went negative, about -37 USD per barrel, while the spot price was close to 22 USD.
Why? This type of WTI future contract requires the delivery of the physical product. As we discussed before, there is not enough space available. Therefore traders who did not want product delivery dump the contract quickly, collapsing prices in the process.
Is this that important? It is indeed. The oil future prices, and any other future commodity price, are used in many physical and financial transactions, or its prices are used as a reference to other contracts.
As an example, most of the ETF that claim to follow oil prices and other commodities, except maybe gold, use future contracts as its investments. They do not use the spot price.
So if you are betting on the change in the price of oil, you must be very careful. You might be investing your money in something completely different from what you expect. The price variations between the spot price and the futures prices, depending on the ETF instruments, because of this reason and others more sophisticated, can be extensive.
The great coronavirus lockdown has taught us that there is a time for everything, even for negative oil prices. What other surprises can this little virus have for us in the future? We will have to wait a little longer to discover them.