Palomar Capital

  • How Can The Price of Oil Go Negative?

    The oil price turned negative for the first time in history on Monday. A strange as this seems it is driven by limited storage capacity and technicalities in how oil is traded. You should not expect the gas stations to pay you to fill up your car quite yet.

    When an investor buys a stake in a company they can hold on and wait for the price to go up. Oil doesn’t work that way.

    If an investor wants to buy oil and profit from its rise in price, they need to have a way of storing it.

    For this reason investors don’t usually buy physical oil, they buy, a financialized version of oil using a derivative known as a futures contract that rises and falls with the price of oil. Futures are legal contracts to buy or sell a particular asset at an agreed upon price at a specified time in the future.

    The problem for investors is that futures contracts have an expiration date when the investor must take delivery of the physical oil.

    Financialized oil today converts into real oil in when the contract expires. Investors often never wish to take delivery of physical oil. They aim to sell the futures contract before it expires, take their profit or loss and move on without ever dealing with physical oil.

    If an investor at the end of May wishes to continue their bet on the price of oil, having bought the May futures contract, they sell those futures and buy the June futures to replace their position. This is known in the industry as “rolling” the futures. As the June expiration approaches, the investor can repeat. They keep their position in financialized oil without the inconvenience of dealing with physical oil.

    An oil ETF (exchange traded fund) appears to give investors permanent financial exposure to financialized oil, but the ETF administrator typically doesn’t own an oil storage facility. They create an ETF by buying futures and rolling them.

    In the end someone must store the physical oil represented by these financial instruments. If oil prices are in contango meaning the next to expire contract is cheaper than the contract expiring a month later, by rolling the futures you are essentially paying someone else to store the oil for a month.

    An investor could right now buy the May contract and sell the June contract, take delivery of the oil in May, store it for a month and deliver it in June making a profit on the storage. The problem is that they would need access to a storage facility where they could keep this oil for a month.

    Oil has not actually taken on a negative value. Oil has a value and investors want to speculate using financial instruments, on its future prices but demand is very low for physical oil right now as the global lockdown has reduced demand and there is limited storage space in the United States.

    Mondays selloff left WTI Crude at its lowest level since record keeping began in March 1983. June prices also fell, but were trading above $20 per barrel. Brent Crude — the benchmark used by Europe, was also weaker, down 8.9% at less than $26 a barrel.

    In economics, products do not ordinarily have negative prices. If nobody wants a good or service, production just stops. But it is not so easy to stop and then restart an oil well.

    The price of the oil contract expiring on Tuesday April 21 has not fallen to a negative price because nobody needs or wants oil. Futures prices show us that there is demand for oil. But today, with the world in lockdown, people need less oil right away and due to limited storage space it is difficult to come up with a reasonable price for oil for immediate delivery.

    To better understand how this works watch this quick explainer I posted on YouTube the day before expiration to explain what was going on.