Oil’s Well That Ends Well? Not This Time!
When it comes to oil and markets, drama’s never been far away. However, an extreme state of play over the past couple of months has forced producers, traders, stockbrokers, and even Invstr into unprecedented action. Here’s what’s going on, the plotline, in full.
The world normally produces about one hundred million barrels of oil per day. It consumes about the same, so we strike an equilibrium. If traders think we get through our supply, the price of oil goes down. If traders think we’ll consume more than our supply, the price of oil goes up. It’s the job of OPEC+ to maintain the equilibrium, a hodgepodge of oil-rich nations including Iran, the United States, Russia, Saudi Arabia, Venezuela, and Algeria.
There’s big money in supplying sweet blends of oil, and each of these countries is very competitive about supplying the global share. They’d love to produce more than each other, but the industry regulates itself because too much oil means lower prices for them to sell each barrel. The respective drilling operations in each country run at a loss if there’s an oversupply, and that’s what gets them in the same room.
There are no prizes for guessing where global oil demand is right now, in the dumps. The world has virtually stopped turning with coronavirus. Naturally, investors expected some major supply cutbacks from the oil-rich nations, but we ended up getting the opposite!
Russia and Saudi Arabia realized their drillers stood in good stead and decided to hike production. It’s game theory; yes, they’re incurring losses, but American drillers are incurring worse losses. Diamond Offshore is bankrupt already, Rystad Energy is on the brink, and this will leave vacant market share for those rebellious drillers, Russia’s Lukoil and Saudi’s Aramco.
Faced with a glut of unwanted oil, we’re running out of places to keep it all. Ocean tankers are filling, and it takes eighteen months to build new ones, while Cushing, Oklahoma (a massive oil storage depot) is nearing its breaking point, and there are environmental qualms with dumping barrels at the side of the road. The bottom line is that we have a historic oversupply of oil plus a historic undersupply of storage, and that means a historically high ‘cost of carry.’
Now, here’s where we traders come in, the chaos, and the suspended instruments.
You can think of oil as having many different prices. It has a spot price, the price a barrel changes hands at today, and it also has ‘futures’ prices (and thus a futures market). The futures market rolls monthly. If you’re an airline and you reckon on needing more jet fuel in six months, you can buy a six-month futures contract. This might be a wise hedge. The oil arrives in six months at a price set in stone today, no surprises. You can plan ahead.
But it’s not just fuel-burning businesses. There are traders in these markets who have no intention of taking physical ownership of oil; they just want to buy and sell the contracts and try to make some gains. After all, one-month, two-month, six-month, and twelve-month contracts are forward-looking, just like stocks, shifting in price with peoples’ predictions of oversupplies, undersupplies, storage levels, and many other macroeconomic factors.
It’s one-month futures causing the market meltdown. They share an expiry each month, their final tradable date before couriers need delivery addresses. Then they roll; two-month futures become one-month futures, three-month contracts become two-month contracts, etc.
Last week as the expiry neared, the ‘cost of carry’ was so huge that no one wanted to take ownership now; no one wanted May’s West Texas Intermediate (WTI) one-month deal.
Traders realized they were standing on hot coals and were desperate to sell to someone, anyone, and any price, and that’s what happened. The market was trading a ticking time bomb, barrels with nowhere to go for minus $41!
This has never happened before, and few brokers were ready to quote instruments at less than zero. Those who took out debt ‘on margin’ and then got caught on the wrong side of this trade saddled stock brokers with unexpected losses. There’s a good chance this will happen again for June’s one-month, and July’s, so most brokers are suspending the trade.
We’re all about simulating the real world at invstr, so that’s what we’re doing, too. WTI and Brent Crude have been halted on Fantasy Finance. We recommend getting your oil fix from exchange-traded funds (ETF) instead, rather than these raw commodities. This is what you would do in the real world, so update the app and check out our new live instruments, #olem and #bno. We also have #uso coming next week!
Ultimately, this was all a matter of price discovery, free markets working their magic. The President likes cheap gas at the pump as it helps him get re-elected, but has to weigh bailing out the drillers and protecting their market share because his electorate won’t accept that.
He did agree a cut to supply with Putin and Saudi King Salman in March, but only at ten million barrels per day, it was a whole lot of nothing. Every OPEC+ member cheats, drilling a bit more than its quota. The good news is that over the long-term, supply will abate, and demand will return. If you can pull off a slick trade here in the meantime, power to you!
