Confusion in the Oil Markets
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As a subscriber you can listen to articles at work, in the car, or while you work out. Subscribe NowHow can the price of anything be negative? If the price on an item is negative, that means the “seller” is willing to pay the “buyer” to take the item. Sound crazy? That is exactly what happened to crude oil in April 2020.
On Monday, April 20, headlines proclaimed that the price of crude oil plunged below zero for the first time in history, hitting a low of -$40 per barrel before eventually settling at -$37.63. However, even as the oil market experienced massive dislocations, you probably noticed that your local gas station was not giving away its fuel for free. So what exactly happened in the oil markets in late April, and what does it tell us about the state of our economy moving forward?
Price of Oil: Spot Price vs. Futures Price
In order to figure out what happened, it is important to understand the difference between the spot price of oil and the futures price of oil. The spot price of oil is easy. It represents the price that you can get for a barrel of oil today; that is, it’s the market price for oil right now. The price of a futures contract for oil is a bit more complicated. As its name suggests, it represents how much a barrel of oil will cost at some future date. The futures market has contracts for the price of oil in monthly intervals for more than a year in the future.
There are two main futures contract providers in the U.S.: WTI (West Texas Intermediary) and Brent. These markets are important because they help businesses lock in the price of oil. This is useful for businesses that either produce and consume oil, because it can help them project their future revenues or costs. Each month when these futures contracts expire in the WTI market, those holding the contract are required to take physical delivery of the oil.
May 2020: WTI Futures Contract Crater at Expiration
When the price of oil goes negative, the price of a May WTI futures contact goes negative, not the spot price. In addition to businesses that either produce or consume oil, the futures market also provides an avenue for investors speculating on the price of oil to provide liquidity into the market. However, these speculators are not in a position to take physical delivery of the oil and are forced to get rid of their contracts at whatever price they could, even if it meant paying someone else to take it.
So why was it so difficult for speculators to get rid of their futures contracts? Several factors caused this unprecedented and historic collapse in the price of oil:
- Severe Supply/Demand Imbalance –Due to the COVID-19 pandemic and the ensuing shutdown of virtually every economy around the world, the demand for oil has plummeted. The demand for gasoline is one-third less than it was before the pandemic, the lowest usage in 25 years.
- Insufficient Storage Capacity –As a result of the low demand for oil, storage capacity across the globe has quickly dried up. To add to the negative pressure on the price of oil, the amount of oil pulled from the ground each day by producers continued to exceed the demand.
- Oil Wars – In early March, an oil price war between Saudi Arabia (via OPEC) and Russia broke out. In response to Russia’s refusal to reduce its oil production in the wake of the COVID-19 pandemic, Saudi Arabia responded by slashing its price of oil and increasing production in hopes of inflicting economic pain on Russia to force them into an agreement.
Where Do We Go from Here?
The U.S. Government’s Strategic Petroleum Reserve (SPR), overseen by the Department of Energy, has begun to take steps to negotiate leasing contracts with oil producers to provide additional storage. In April, 1.1 million barrels were delivered to the SPR, which has a total capacity of 23 million barrels. This extra storage should help ease some of the short-term pressure on the price of futures contracts, but will not solve the general glut of oil in the market.
Volatility in oil is nothing new, although several simultaneous shocks have caused a dislocation in the oil market that has never been seen before. Until the global economy emerges from the coronavirus lockdown and begins to ramp up commerce, decreased demand should continue to keep downward pressure on the price of front-month futures contracts as additional private storage will likely remain constrained.
Consumer Impact
As you can see, there are many variables that impact the price of crude oil. Ultimately, the crude oil price influences the price of a gallon of gas. As consumers, we have benefitted from all the confusion in the oil markets. For example, on April 27, 2019, the “US Retail Gas Price” was $2.97 per gallon. One year later, April 27, 2020, the price was $1.87, a reduction of 36%. Enjoy it while it lasts!