What Does It Really Mean When Oil Prices Go Negative?
Well for starters, you don’t want oil when it happens.
This past April, the prices of US crude oil went negative, meaning that sellers paid buyers to take oil from them.
The drop in demand for petroleum products was a result of COVID-19 as people weren’t driving cars, working in factories, or flying due to restrictions on travel.
Global energy demand plummeted in one of the most rapid supply shocks of the modern-era, and in short, some traders got caught holding the bag.
With A Drop In Demand, Why Not Slow Down?
Despite the drop in demand, oil producers continued to produce as they couldn’t reach an agreement in rebalancing the supply and demand. As refiners didn’t need all of the oil, this resulted in large amounts of spare oil that needed to be stored.
And In Comes Futures Contracts
Many companies frequently use futures contracts to hedge the price of oil and energy. Oil companies will sell futures contracts for oil, allowing them to lock in the current market price and more easily forecast revenue. Then airlines and the cruise industry, for example, can project their expenses by purchasing futures contracts. That way, if oil prices change over the course of the year, these industry have already secured their rate.
At least, that’s how it works and sounds in theory. The challenge with futures contracts, particularly in the oil industry, are that massive demand shocks resulted in plummeting demand for oil futures.
That was particularly true for oil futures that had close expiration dates. Because at the expiration date, the oil future becomes more than a piece of paper. The owner has to take delivery of the oil.
In typical market conditions, investors could pay companies a nominal fee to store oil if they did take delivery. But as US Traders realized there would be no space to store oil once purchased, a selling frenzy ensued and prices began to drop sharply. Traders who typically trade the commodity electronically, had to pay to get rid of their contracts because they had nowhere to store it — otherwise known as negative pricing.
More Oil Gluts Going Forward
The future (sorry for the pun) does not look like it’ll be improving. Global energy demand remains incredibly low and the growth prospects are not promising. Major over-expansion of US shale fields has left countless companies desperate for any revenue.
That means that as oil prices do rise from any supply cuts, the economic incentive will be too great to stand by; and as such, the supply will increase once more, driving the price down.
It’s good to have warehouses or oil tankers right now. Because you can’t just dump oil and even if investors don’t like, they have to take delivery if they own a futures contract and it expires.
