How can the price of oil be negative?

price of oil be negative

2020-05-17 11:42:00

The results of oil exchange trading on Monday will be included in the history of economics.


The futures market for West Texas Intermediate crude oil with supply in May on Monday, April 20, opened on the New York Mercantile Exchange (NYMEX) at $17.73 per barrel WTI.


Later in the morning (UTC -4), prices fell by 83% to $2.96 per barrel. At of 1:00 p.m., the price fell to less than $1 so it is the lowest level in history. At 2:00 p.m., the price fell to 6 cents (-99.67%) in one day. Then there was a slight rebound of 20-30 cents. Around 3:00 p.m., the price fell at a peak: to $-37.63 per barrel, but then rebounded to $-25−26 and with francit volatility spun in the range between $-40 and $-20 per barrel.


The minimum level for the day was $-40.32 per barrel - an absolute historical minimum for the entire time of oil production since the end of the 19th century. In the evening, the WTI futures market for May delivery closed at $-37.63 per barrel, i.e. $-55.90 per day (-312% per day).

I have never seen such a thing in my life and have never read about it. Market veterans say this has never happened in history before.


In order to understand the reasons for the oil price drop, it is necessary to make several reservations:


  1. Generally, the situation on Monday did not concern whole oil, but only WTI crude oil (West Texas Intermediate). According to Reuters, oil quotes in the European spot market also went negative in the evening, but not so crucial for Urals and Brent.


  1. The instrument we watched on Monday is futures on WTI, which is traded on NYMEX with CL ticker. Futures on Brent and Urals also declined, but not that much;


  1. The peculiarity of this instrument is not a financial (or speculative) instrument, where the calculation takes place only in money, depending on who is better at guessing the course for a certain date. CL is a delivery contract (contract which is settled physically), i.e. the one who sells it (short side) is obliged to deliver oil to the buyer (long side), who is obliged to physically accept it (there are no such strict conditions for Brent oil). In other words, the seller must have oil, and the buyer must have contracted physical storage facilities for pumping purchased oil, most likely at Cushing in Oklahoma this port is most often used for shipping WTI oil;


  1. We are talking about the price of delivery futures in May 2020. The price of the June contract for the supply of WTI oil on Monday didn’t decrease too much: by 14.1%, to 21.5 per barrel.


Summing up, we are talking about a specific asset: futures contracts traded on NYMEX (CL ticker) for the physical supply of WTI crude oil in May 2020. Don’t forget that.


What were the reasons for that fall? Expert opinions revolve around the following key factors:


  1. The fall in oil demand due to pandemic has reduced domestic consumption, including due to the end of the heating season. Car owners have reduced consumption at many times. An important factor is also the limitation or even absence of passenger and industrial flights. In many countries, an economic downturn also reduces the demand for energy commodities;


  1. Continued growth in oil supply in the market. It began when OPEC member countries planned to reduce oil production amid falling demand, but could not agree eventually. Russia withdrew from the OPEC agreement, and Saudi Arabia decided to increase oil production, instead of reducing it. Other cartel members took the same step for Saudi Arabia, as they feared of future price lowering and wanting to sell more oil right now.


Such coordinated frenzy led to a further collapse in oil prices to twenty-year lows. 10 days ago, the OPEC countries nevertheless reached new principal agreements on the conditions for reducing oil production (by about 10%). But these agreements will only take effect in May, and according to them, countries will only gradually reduce production. But oil needs to be loaded into storage right now, when the production is still large.


It is worth saying that most experts believe that a decrease of 9.7 million barrels per day will not stabilize the market, and OPEC should meet again for a new agreement. As a result, there is a huge excess of supply over demand today, which must either be refined or saved, expecting more demand in the future. According to the US Department of Energy, the daily volume of oil refining has been declining for the second week in a row, oil reserves over the past week have grown by 19.25 million barrels, exceeding experts' expectations by 1.5 times. If you bought this contract, then the oil must be pumped somewhere, but oil storage is clogged and is also not an option to drain into the ocean.


The fact that tankers that plow the sea from Singapore to New York also have accumulated a record 160 million barrels of crude oil is also an additional bad new to the market (instead of the logistic function, tankers are now used as mobile storage facilities, and they simply have no place to unload).


A question appears: why did the fall happen on this black oil Monday?


The fact is that for most traders, futures are still a price hedging tool, and for some, a speculation tool. Those futures contracts for May stopped trading on April 21, that is, Monday, April 20 was the last day of their trading. The futures themselves were in the hands of those who planned to buy oil, and those who simply hedged their risks. Oil prices falled in recent weeks, and those who held futures in their hedging portfolios decided to sell them, and Monday April 20 was the last day they could do it. They needed to either sell futures or to physically buy oil;


But there weren’t much buyers. Moreover, those merchants who planned to buy WTI oil for themselves for delivery in May realized that it would be difficult for them to find physical storage facilities for storing crude oil as all storage facilities are already full.


Therefore, this day became black for the oil market because supply and demand did not coincide at the same time, and limitations in storage volumes could not compensate for this gap.


And then the third question comes: what do these negative oil prices actually mean?


We all remember the problem of fixed costs during a crisis: variable costs decrease with a decrease in production, but fixed costs remain, according to the economic theory. Price dynamics on Monday showed that for some oil producers it is cheaper to sell oil at any price now than to stop its production, even at a negative price.


The negative price for futures meant the following: the seller of the futures contract will pay more than $30 to the buyer of the contract for buying crude oil from him and then uploading it to some of his contracted storage facilities.


Such situations with a negative price for futures contracts sometimes happen. Sellers simply calculate their opportunity costs of owning a contract, and if these costs are higher than losses from a negative price, they can sell assets below zero, i.e. paying extra costs to buyers. It is worth saying that for those who had places to unload oil, it was a very lucrative deal.


What's next?


I don’t think this one-day anomaly will affect the future of the oil market. There are many additional factors for its development: further OPEC actions to limit production, the duration of the COVID crisis and global lockdown, the gradual increase in economic activity in different parts of the world,  the influence of green technologies. Futures for June are at the level of 420+ dollars per barrel.


But Monday, April 20, 2020 will go down in history for sure. And the remaining months of 2020 promise to be no less exciting.



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