Sub-Zero Oil Explained
Yesterday, sellers were paying buyers to take barrels of West Texas Intermediate (WTI) off their hands. This is something incredible that economists never predicted. Historic, wild, dramatic; all of the above! Here’s what it means, and here’s what will happen next!
Companies can lock in future prices for commodities they plan to buy. Airlines do it for fuel because they don’t want higher kerosene prices to sneak up on them. It’s a wise hedge. It makes sense. It’s for peace of mind, but nothing in life is free. A predictable future always costs a premium to prices in the present (current prices are ‘spot’ prices).
Say Amalgamated Widgets locks in an oil price for March 2021, it uses a twelve-month futurescontract. The above-spot premium is about 10%, quite large. If Amalgamated Widgets locks in an oil price for July 2020 (in three months), it uses a three-month futures contract. The above-spot premium for that is about 49%, huge.
Higher than usual premiums are underscoring an acute concern. Amalgamated Widgets is terrified of black gold. There’s a massive oversupply, and there’s almost no storage left. We’re out of landlocked batteries. We’re testing the limits of our ocean tankers. Soon, we’ll be filling closed swimming pools and lining up barrels along the side of the highway!
Any secure storage costs a small fortune, so Amalgamated Widgets’ futures contract has backfired. It got the stable commodity price down pact, but much higher storage costs have snuck up on it!
Yesterday, with the surprise losses of a legendary Singaporean oil trader, millions of Amalgamated Widgets’ panicked. One-month futures contracts stipulated that companies and traders take delivery of oil in May, but now everyone could see how little storage there was, and no one wanted the deal.
With the futures expiring yesterday, the contract owners were standing on hot coals. They were desperate to sell to someone, anyone, at any price, even negative, and that’s what happened. A multi-billion game of musical chairs left WTI one-month futures contracts completely destroyed, falling as low as -$40, upending the global oil industry!
It’s a front-month blowdown, a great spectacle, but what next? Investors should expect every month’s set of contracts to slowly go sub-zero until oil supply goes below oil demand. Gas prices will fall somewhat, but there’s a few weeks’ lag time, and remember, the government relies on gas for tax. Your gallons will be cheap, but not that cheap!
This crisis could force oil wells to shut, which typically take time to reopen when economic conditions improve. That would lead to a ‘supply crunch’ and oil prices soaring into the hundreds of dollars when we’re post-corona. Alternatively, refineries could decide closing is too expensive. They might lose less if they just keep pumping.
In conclusion, though, this is a great time to watch and learn from a market event that may never occur again in our lifetimes. If you can profit from it, even better, but most important is to keep your eyes and ears open!