Making Sense of Negative Oil Prices
Summary:
Global oil prices are collapsing, largely due to COVID-19
West Texas Intermediate (WTI) futures contracts for May delivery settled at - $37.63 on April 20th as buyers of these contracts scrambled to sell out fear of not having storage in Cushing, OK
While commodities can provide diversification, the recent oil price collapse serves as a stark reminder that commodity allocations can introduce other risks to a portfolio
Global economic activity has largely halted as many around the world find themselves following orders to shelter-at-home due to the current COVID-19 pandemic. This has sent global oil demand and prices plummeting. The International Energy Agency estimates April’s demand for oil was 29 million barrels/day lower than a year ago. Further, consider that Russia and Saudi Arabia locked into a price war in early March, exacerbating the fall in oil prices. These two events have created the nasty storm currently roiling the oil markets.
The collapse in global oil prices has been felt most in West Texas Intermediate (WTI) futures contracts[1], a common North American benchmark for oil prices. Cushing, Oklahoma has long been the primary locale for buyers and sellers to transact and store WTI. This small town contains an extensive network of pipelines connecting suppliers and refiners in North America.
With the world awash with oil, storage is scarce - even more so in landlocked Cushing. It is reported that storage in Cushing’s oil tanks will completely full this month. Producers keep pumping. Downstream companies aren’t buying due to a lack of demand. Further, there are logistical issues for those who have alternative means of storage elsewhere but must take delivery in Cushing.
Just before the May contract expired, a bizarre thing happened; the price of WTI May contracts fell below zero and closed at -$37.63 per barrel. Traders were left scrambling to sell for fear of taking delivery and not having a means to store the oil.
It is important to note – the move in WTI was not indicative of broader oil markets. However, this isn’t to say that negative prices couldn’t happen in other variants. Brent Crude, another commonly referenced benchmark, did not and has not crossed into negative territory yet; although, it is trading lower due to the same headwinds mentioned above. The location of Brent Crude, a seaborne crude, allows for more flexibility in terms of storage and delivery relative to landlocked Cushing.
Most commodity investing is done through these financial contracts, which come with other complicating aspects and risks. Investing in futures requires continual rolling of the futures contracts by selling near-term contracts and buying longer-term contracts. This avoids taking delivery of the physical commodity but can be costly when short-term contracts trade at lower prices than longer term contracts, as they do now in WTI oil. Over time and given certain economic environments, following this process blindly can negatively impact investor’s returns.
It has never been easier to get exposure to alternative asset classes like oil and other commodities through exchange-trade funds (ETFs) or other investment vehicles. But that doesn’t mean it is a good idea. With oil prices near historic lows, they may appear as attractive investments. However, in practice, it may be difficult to reap the benefits of the apparent opportunity. It is important to consider the risks associated with how these financial instruments gain exposure to alternative asset classes.
[1] A futures contract is a standardized agreement between a buyer and a seller to transact in a certain amount at a predetermined price on a specific date in the future. The expiration of these contracts is before contract settlement. After expiration, the buyer is legally obligated to take physical possession of the commodity from the seller. Some (e.g., corporations) utilize these contracts to hedge the price of oil; others (e.g., hedge-funds and other financial market participants) make speculative bets on price direction and sell prior to expiration to avoid delivery.
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