The financial markets experienced a historic day yesterday. Crude oil barrels traded negative for the first time in history. The mismatch between supply and demand caused something that had never happened before. What is the cause of this totally anomalous situation?
The price of Crude Oil West Texas closed yesterday at -37.63 dollars, which means that producers or traders paid buyers to remove the oil from their hands.
In recent weeks, oil demand has fallen by more than a third globally, triggered by the coronavirus pandemic. This represents a cut in consumption of around 29 million barrels per day, according to The New York Times.
Since the oil market is an oligopoly , very few producers control the market. The main oil-producing countries ( OPEC , Russia and the United States) decided two weeks ago to cut oil production by 9.7 million barrels per day, to adjust to demand and prevent the price from falling further.
Anyone who knows how to add and subtract, knows that the cut in supply (-9.7 million) has not served to adjust to demand (-29 million). Faced with such excess supply, both oil consumers and producers have begun to store their excess oil. China, for example, is taking advantage to buy huge amounts of oil at these levels.
However, oil storage has a limit. Consider that a barrel of oil is 60 cm in diameter. With which the daily oil surplus occupies about 11,580 km in a straight line.
In addition, storage costs are becoming more expensive. So there is a point where oil storage is more expensive than the cost of oil. At that point, oil sellers, who have nowhere to store oil, are forced to pay to dispose of their oil barrels.
How is the price of oil negotiated?
The price of oil is negotiated in barrels and its commercialization is largely done through futures contracts . That is, contracts that, when the expiration date arrives , oblige the buyer of the future to acquire the underlying asset and the seller to deliver it.
In other words, if we are buyers of an oil futures contract and when it expires, we continue to be the contract holders, we are obliged to acquire the oil barrels physically. This entails a series of obligations such as buying the barrels and storing them. Each contract on oil (underlying asset) requires us to buy, specifically, 1,000 barrels of oil. So, taking into account that each barrel has about 160 liters, where do we store 160,000 liters of oil?
Given that the diameter of a barrel of oil is approximately 60 centimeters and assuming that we do not stack them, we would need a surface that is 60 meters long by 6 meters wide. A size similar to 3 tennis courts. And this for each contract. Therefore, we would have to bear the cost of having an approved place to store these barrels.
Why did this happen?
As we saw above, markets move mainly by the law of supply and demand . Supply is defined by oil production and consumer demand for it. Thus, the economic crisis caused by the Coronavirus epidemic has led to a historic drop in demand for oil. If economic activity is paralyzed (and not only economic), the use of fuel is greatly reduced. This, added to the excess supply caused by the large quantities produced, causes a shock in the market.
In other words, many more barrels are produced than are consumed. Which forces oil buyers to have to store that oil before finding new buyers. Therefore, as long as consumption does not increase , oil buyers in the markets are obliged to bear the costs of storage. The result? Negative price.
Buyers do not want to buy the oil because storage costs are expensive. Producers are therefore obliged to bear these storage costs. And how do they do that? Paying buyers to get the oil off their hands.
How can you take advantage of the fall in the markets?
The bad news is that, unless the rules that require operators for physical delivery are met, we cannot take advantage of this movement, unless we are an institution with the capacity to store that oil. In other words, if they pay us to buy oil, we will be obliged to keep it and store it.
In fact, the expiration of May can be financially negotiated until April 21, thereafter, the agreement for physical delivery can be closed, which becomes effective from May 1. Futures traders do what is known as a “rollover”, which consists of selling the future of the month that expires, and buying the futures of the next expiration.
Contracts with expiration in June onwards are currently being negotiated. Consequently, the fall has been accentuated by the fact that many operators do not want to keep the oil physically and sell their May contracts at any price to avoid the beginning of the physical delivery period.
An example of large sellers doing these rollovers are ETFs that replicate the performance of WTI Texas oil. They have been forced to sell the contracts expiring in May to buy the contract expiring in June.
But not all oil contracts were negotiated in negative territory. If we wanted to buy oil as private investors, we would have to buy the West Texas future in June, which closed yesterday at $ 20.43, 17.5% less than the previous day. What is still far from negative prices. This is because the market expects the problem of mismatch between supply and demand to be resolved by June. That the future price is higher than the current price is known as contango .
Brent oil, extracted in Europe and an international benchmark, fell 9% yesterday to $ 25 per barrel. It remains positive due to the fact that the contract expiring in June is being quoted.
