21 Apr First time in history: oil price went negative
Analysis, fundamental preconditions, possible scenario
We witnessed a historic event yesterday no one could imagine – the WTI oil price dropped below zero. It means producers paid buyers to take oil off their hands. Just imagine: you go shopping, you take your goods and the seller pays you for that!
This situation seems unnatural in market economy conditions, doesn’t it?
However, the chart above proves that this situation is real. We see that the May WTI oil futures price reached a record low of negative 49.32 USD at New York Mercantile Exchange (NYMEX). The May futures expire on 21st April, so the delivery price is fixed on the last trading day, 20th April, and equals negative 37.63 USD.
Next, we see a rebound to a positive value of 1.38 USD. This rebound is technical. Oil suppliers aren’t interested in shipping loads of money on top. So, they made a technical buyback using collateral money. This picture may look like unprecedented generosity: you make over 40 USD per 1 bought barrel out of nowhere. In fact, it’s not that simple.
Only institutional investors may access NYMEX: big commodity brokers, oil producing and processing companies or big plants.
In essence, a delivery futures contract becomes a regular buying/selling contract upon expiration. This contract obliges sellers to deliver oil while buyers are obliged to take delivery and transport oil. The Exchange itself guarantees that the transaction will be executed. A refusal to observe these obligations entails legal consequences and may result in bankruptcy and enormous penalties.
Small traders and private investors such as you and I don’t have access to this mercantile exchange. That’s why CFDs (Contracts For Difference) exist. They satisfy our demand. It’s the quotes of this contract that Forex brokers provide. As the name suggests, it’s not the asset itself that is traded but the difference in buyers’ and sellers’ prices. Such contracts don’t have a period of limitation and they don’t oblige sellers to deliver an asset or buyers to take delivery. That’s why we weren’t able to buy oil at a price below zero.
Most likely, the price you can see looks like the following:
It may vary from one broker to another, but in general the picture is the same. As the chart above shows, the lowest price of 1 CFD contract in WTI was at around 16.71 USD.
So why did the commodity market slump?
The thing is, only 3% of deliverable futures are executed, even if we are speaking of NYMEX. Brokers use these contracts for speculation, earning from the difference in May and June futures prices. The difference occurs because settlement takes place later.
If I were a big trader with huge oil storage facilities or with enough money to rent such facilities, I could buy oil in instalments and resell it next month when a deliverable futures contract was settled.
I placed the charts of the May and June WTI futures above. You see that the June futures price is much different and is currently located at 21.41 USD. If I were sure that the price remained the same upon settlement in June, I could resell oil at that higher price, pay my supplier and profit from that difference in prices.
And here we have come to the essence. Market analysts said as early as at the end of March that considering current demand for oil, the world’s storage capacity would withstand the glut no more than a few months. However, a report published on 15th April made it clear that demand had dropped by another 19 million barrels a day. It means, the US oil storage facilities will be overwhelmed in May.
Speculators realized all the risks the day before contracts expiration and started selling contracts “at market”. Because many of them had been using leverage, mass liquidation of positions and panics began. Obviously, such a fierce collapse wasn’t caused by fundamental factors. It was due to market panics.
This panic is based on a fear that resellers won’t find a buying counterparty in June. Oil production can’t be cut so sharply in a second for technical reasons, that’s why oil producers have to pay buyers. If oil delivery is stopped, there will be no place to store it. Producers will puzzle over its utilization or they will have to simply pour it out, which will provoke an anthropogenic catastrophe.
This situation reminds of the times of Great depression, when farmers would pour out unpurchased milk. You can’t order a cow to stop producing milk. Without regular milking, cows become less productive and may even develop concurrent diseases. So, to avoid such consequences, farmers had to pour milk out into the ditch.
The pictures above are a bright proof of that.
Still, oil isn’t milk and can’t be poured out. So, unlucky producers have to pay buyers and get rid of their liquid gold as soon as possible.
However, this situation was quite predictable. Lower-quality oil brands traded below zero as early as at the end of March. For example, Wyoming Asphalt Sour. Similar cases were registered in 2014 and 2016. So, a precedent of negative prices has already occurred. However, it’s the first time in history when benchmarks dropped below zero.
What will happen to WTI next?
It’s difficult to make relevant forecasts when market mechanisms aren’t working properly. But the historical chart of the WTI non-deliverable futures contract shows that the oil price has never gone below 10.75 USD, even during the crisis of the early and late nineties. Being a small trader, I think this level is a good buying reference point.
The situation with oil overproduction is temporary. No business can operate at loss for a long time. So, the invisible market hand will fix everything. Weak companies will go bankrupt and strong companies will cut output and find a balance between demand and supply. Any crisis is temporary too. Economy will recover sooner or later. Borders will reopen and factories will start working. So, demand for oil will grow again. The question is, how fast the recovery will be. Much depends on the current global lockdown. Another wave of the pandemic that many analysts are forecasting may worsen the situation too.
The time will show the way it’s gonna be. I’ll continue sharing my ideas here.
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I’d like to remind you that all materials are provided for educational purposes only. They aren’t financial advice and don’t guarantee any profits. All trading decisions you make are your responsibility only.
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