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Affluent Christian Investor | May 27, 2020

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How Can Oil Go Negative?

On Monday, April 21st, oil went negative for the first time ever. To be specific, “the thinly traded, soon-to-expire May contract for West Texas Intermediate crude on the New York Mercantile Exchange traded, and closed, in negative territory,” according to MarketWatch[i]. Some were left wondering how such a thing was possible: How could it be that suppliers were willing to pay some to take a commodity off their hands? To understand how something like that can happen, we first have to recognize the unique situation at hand. With the ongoing economic shutdown across the world, demand has plummeted.

In their recent report on the phenomenon, Statista described[ii] the situation succinctly:

“With much of the world on lockdown, fleets of airliners have been grounded while cars are parked up, resulting in a lack of demand. That has in turn led to a glut of oil that’s clogging up storage facilities, further impacting the price.”

Oil can be expensive to store in high quantities which means that when demand drops enough, it might actually be the better financial decision to sell it at a loss, as MarketWatch explains in their report,

“Negative prices means someone with a long position in oil would have to pay someone to take that oil off of their hands. Why would they do that? The main reason is a fear that if forced to take delivery of crude on the expiration of the May oil contract, there would be nowhere to put it as a glut of crude fills up available storage.”

What we saw recently with oil prices is an example of the “contango” phenomenon. As explained by Investopedia:

“Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. This results in an upward sloping forward curve.”

As you can see in the image below from a VisualCapitalist report, oil prices were very low on the 20th and 21st, but projected prices were much higher. The same market that was pricing oil negatively for May is pricing it positively over the summer.[iii]

(Source: VisualCapitalist)

That’s how oil can turn negative: historically low demand coupled with high supply. Next time, we’ll look at the broader context to see how significant this market idiosyncrasy is for the broader economy.

[i] MarketWatch, Why oil prices just crashed into negative territory – 4 things investors need to know, April 2020

[ii] Statista, U.S. Oil Price Collapses To Lowest Level Since 1999, April 2020

[iii] VisualCapitalist, How Oil Prices Went Subzero, April 2020

 

 

Originally published on Townhall Finance.

 

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