On Monday, April 20, the prices of May 2020 oil futures made an unprecedented move by selling off so much that they ended the day negative – meaning producers are actually paying someone to take oil off their hands. Although those who work in the energy industry understand how oil and gas contracts work, now is a good time to refresh the rest of us.
Commodities like oil trade on futures exchanges where one contract is equal to 1,000 barrels of oil to be delivered on a future date. When you buy one of these contracts, you’re effectively buying the obligation to take delivery of that oil. However, if you sell your contract to someone else, you no longer have the obligation to take delivery. Due to the high volatility in futures markets, many traders participate in hopes of generating high returns. As contracts approach their expiration dates, volatility might increase as the price reaches the “real” price of oil. This often happens because traders who do not wish to take delivery decide to close their positions.
With demand for oil at or near all-time lows due to the coronavirus pandemic, traders not equipped to take delivery of physical oil began selling to close their contracts before they expired on April 21. With storage facilities at capacity, those who would buy the contracts and take delivery of the oil typically had nowhere to put it. When these two factors combined, it created a panicked sell-off – pushing prices down over 300% to -$37.63 per barrel. Some have claimed that the main culprit was Exchange Traded Funds (specifically USO) that held a large quantity of these open contracts and had to sell them in a hurry.
It’s important to note that prices of contracts set to expire in the current month can rise or fall drastically compared to those set to expire next month or longer contracts because they react in real time to supply and demand news. The long-term estimate of oil prices will be more accurately reflected in longer contracts. For example, at the time of this writing, December 2020 WTI contracts are priced at $27 per barrel. This isn’t to say that these contracts won’t react to their own bad news as they reach their expiration dates, but lower rig counts, a cut in OPEC+ output, and an assumed increase in travel with our eventual return to normalcy lead us to believe that these prices are a more accurate reflection of the oil industry.
Additional Sources:
https://www.cnbc.com/2020/04/20/this-oil-price-crash-isnt-as-bad-as-it-seems-heres-why.html
Category: Financial Service Team
