Why Did Oil Drop Into the Negatives?
On Monday, April 20, 2020, the price of US oil dropped to -$37.63. This was shocking, bringing attention from across the globe. But why did oil drop so low, and why into the negatives?
A clarification.
Oil as a whole didn’t drop into the negatives. More specifically, the May 2020 futures contract for West Texas Intermediate (WTI) is what fell into the negatives. June 2020 contracts, along with Brent Crude Oil did not go negatives at the time. Before we explain why the May 2020 futures contract went negatives, lets first explain Crude Oil futures.
How Crude Oil futures work.
Crude Oil futures are traded on the NYMEX with the ticker symbol CL, between 6PM to 5PM ET. These contracts contain 1000 barrels of oil that are physically delivered once the contract settles. What this means is that when the May contract settled, traders who held onto a call (in other words, bought the contract) are responsible for the physical delivery of the oil.
Why did the May 2020 futures contract go into the negatives?
Not only was there an increased supply and decreased demand as mentioned in my previous article, but there was also no place to store oil. The May contract expired on Tuesday, April 21, and with traders not able to store oil at facilities meant to store the commodity, they were forced to sell their contracts beforehand even if it meant that they would be paying another person to buy it. This loss would be less than the cost of carrying oil.
A quick lesson on contango.
If you were looking at the price for all futures contracts, you would have realized that as the time till the contract settles increases, the price of the contract also increases. The general reason for this is because of the cost of carry, such as storage costs and insurance. However, overtime this spread in price reduces as the contract’s settlement date approaches. In many markets, such as with Bitcoin, traders can take advantage of the contango. This is done through an arbitrage, where traders sell contracts with a large premium and buy spot to lock in a profit.
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