Skip to main content

How Do Oil Prices Go Negative? And What Does That Mean?

By April 21, 2020February 12th, 2021Videos

How does oil go negative? And what on earth does that mean for the rest of us? Well, earlier this week oil prices collapsed. Momentarily, futures hit -$40. But was that a true reflection of the market? I mean, if we look at Brent, which is another commonly traded sweet crude, their prices hit closer to 20. This does suggest that there’s more going on here than just simple supply and demand. What on earth happened? Well, first there are two things. One, in Texas, just like everywhere else, it’s very difficult to completely shut down an oil field. When you turn off the spigot, that pressure doesn’t just dissipate It can cause damage to the field. Two, because of the collapse in demand in the United States and the fact that the rest of it must be exported, we have a scenario where no one can take the oil. No one has anywhere to put it. There’s a complete shortage of storage.

So we are in this unusual scenario where at least in the very short term, it makes more sense to pay someone to take it off your hands than to turn off the field and damage it. Yet, within a day or two, we’re already back to $10; hovering in this positive range. So surely that can’t be all there is to this – a supply and demand imbalance. And no, you’re absolutely right. There’s a fancy word called contango. This can’t simply be supply and demand. Even though the spot rate for tankers has gone through the roof – it’s about 20 times what it was about a month ago. That doesn’t explain a two-day downdraft. Contango, on the other hand, does. And contango is basically related to the rolling of futures contracts. ETFs and other investors, mutual funds…they don’t like buying oil and putting it in a tank and selling it later. So when they want to invest in oil or gold or many other commodities, they actually use something called a futures contract. And in a normal market, that’s okay, but in a market where not only now is there a mismatch between supply and demand. But also a month from now – then we get in the scenario where nobody wants those contracts. And the bid/ask spread between the contracts, between the buyers and the sellers, just grows and grows and grows until finally someone, some bargain hunter somewhere takes that. And this now gets into the danger of investing in commodities, especially the retail level. Especially through exchange-traded funds.

These ETFs don’t own the underlying commodities. They own the futures contracts that simulate the commodities. And in normal environments, that’s okay. One of the shortcomings of contango and futures contracts is that even when oil goes up, there are frictional losses in the contracts which mitigates the benefit for commodities, ETFs. Contracts, futures contracts, options…they’re insurance products. And like all insurance, there’s a premium. And over time that premium costs money. It’s actually one of the reasons we left commodities about 10 years ago. One of the other reasons is throughout the history of the planet, over time we become more efficient at pulling commodities out of the ground, either gold, silver or oil, and over time those commodities lose value. Far better to invest in the producers, the miners, the drillers. If you want exposure to these commodities, it’s actually better to have exposure to the industries that extract those commodities.

So there’s a number of lessons here. One, is as a retail investor without good advice, without good consulting and counsel, you can really wade into mistakes like buying a commodities ETF, buying an oil ETF, maybe even gold. There’s another lesson here. In the intermediate term, we’re still looking at huge drops in the price of oil. There is massive demand destruction and it is anticipated to go out through the end of May. These markets are not stupid. That really indicates just how wounded the global economy is and if the wounded economy really is in sufferance, is in pain, where does that leave markets and market valuations? That somewhat explains why the markets have been falling the last two days, also. And I’m sure there’ll be a point where there are some opportunistic buyers, but people are going to get tired of this high volatility. They’re going to get tired of whiplash.

Slowly these markets are going to find a true, new equilibrium. One that matches the future value of earnings. A future value that is significantly lower than what we had just three months ago. So where does this leave the small investor? This is a difficult environment, one which you should handle with care. A perfectly acceptable strategy is to do absolutely nothing. Hold on for dear life. Rebalance on the way up and down. That is a proven time-tested strategy. These are not normal times, and those who have rolled back are also in a good position. In fact, right now, they’re in a great position, so long as they have the discipline to strategically roll back into the market. Nice, even chunks. Be it three months, six months, a year, whatever. Be disciplined, be strategic. And remember in the long term, when this is all over, even more than before, equities will be the best game in town. We’d be happy to talk to you about that. Meanwhile, we wish you the best of investing success and remember, handle with care.

 

Source:

https://www.economist.com/graphic-detail/2020/04/20/american-crude-oil-has-fallen-to-less-than-nothing

Next post: 4 Phases of the Impact of Covid-19