Negative Oil Futures – How Does That Even Happen?

Eric Brown - Apr 22, 2020
We’re seeing an unprecedented decrease in the demand for oil during the COVID-19 crisis.

For the first time in history, the price of West Texas Intermediate (WTI) oil was below zero. What does that mean, and how does that even happen?

The price of oil is based on the trading of investments called futures contracts. Futures contracts are essentially agreements to buy oil at a certain price on a certain day. Typically, these contracts expire one month out and are purchased in advance. ("The day oil was worth less than $0 — and nobody wanted it", www.cbc.ca)

What can be confusing is that even though the headlines say WTI is negative, when you look up the spot price of oil, it’s not negative but showing around $15. The spot price of WTI or the price that you would see if you looked up the oil price is based on a contract that expires in June.

The WTI contract that went below zero is the May contract, which expired April 21, 2020 (remember contracts are purchased in advance).

An important thing to know about the WTI contract is that if you are holding the contract when it expires, then you have to take delivery of the physical oil. There’s nothing like having a big shipment of oil barrels coming your way if you don’t want it.

We’re seeing an unprecedented decrease in the demand for oil during the COVID-19 crisis. With people not flying, going on ships, or driving as much, the usual use for oil and its products is not happening. Storage at US oil-hub Cushing has already grown to more than 15-million barrels in the past month – and is expected to soon be at capacity for the first time ever ("Coronavirus: Oil plunges for a second day on gloomy outlook", www.bbc.com). Even while this is happening, oil companies are still continuing to produce oil, but now there are less markets for their oil, which means the oil has to be placed in storage. However, traditional storage is being filled up because there’s so much excess oil being created.

That leads us back to the expiring May contract and the nasty game of hot potato that is happening.

No one wants to be holding the contract when it expires. That means you get delivery of the oil, which means you have to store it somewhere, but you can’t. You’re desperate to get rid of it, so you keep lowering the price you’re willing to accept. Everyone is having the same problem, so it’s hard to entice others to take the contract off your hands, even at a low price.

You become so desperate to avoid taking delivery of the oil, you will pay someone to take the oil off your hands, and there’s your negative price of oil. You’re paying someone else to take the oil contract you have.

At what point does this stabilize? When demand for oil increases as airlines start up again, people start going on cruises and businesses start opening their doors.

If you have any questions or want to talk to me about investment opportunities in these challenging times, please reach out to me at 780-408-1508 or ebrown@cgf.com.