Oil Below Zero! How Did That Happen? What Does It Mean?

In the normal course of events oil gets pumped out of the ground and put into a complex supply chain consisting of pipelines, tanks, tanker ships, refineries, more tanks, tank trucks and underground tanks at your gas station before it’s pumped into your car’s tank as the last stop before being converted into deadly emissions. It’s pumped into one end of the supply chain and pumped out of the other.

Most of us don’t give too much thought to this exceedingly complex process. We simply pay the spot price for the gas whenever we pump it into our cars. The spot price is today’s price wherever we happen to be. That spot price goes up and down depending on the season and other supply demand factors. But then again most of us are simple retail consumers. For all we know, gas grows under the pump at the station.

But embedded in this almost magical supply chain are a large number of institutional buyers that would prefer to have some control over future prices they will have to pay. So, they enter into contracts for future delivery at known prices. Airlines, cruise ships, and refineries are good example of companies that would like some certainty over their future costs. They can if they care to buy any amount of oil products for future delivery at a fixed cost. Importantly this is not an option to buy, it’s a guarantee to buy and take delivery.

To facilitate and simplify this process an entire marketplace has evolved to trade these contracts. These contracts mature on fixed future dates, and while the contracts may be traded freely until they mature, at some known date in the future somebody is going to take delivery of the oil and pay up. Speculators who don’t really ever want to take delivery participate in the market buying and selling the contracts in the hope of making future profits from the changes in prices.

So far, so good. But suppose some unforeseen event causes a huge decrease in demand for oil products. For instance a world wide pandemic that cuts auto travel, cruise ship and airline schedules, and other uses for the oil.

Further imagine that at the same time some of the world’s largest producers of oil engage in a price war, pumping far more than the consumers need or want. They just keep pumping far more than the consumers need. Prices spiral down on the spot market.

Unfortunately, today no matter how low the price goes, consumers are not likely to go for cruises, road trips, or jump on an airline.

So, pretty soon all available storage areas fill up. There are no more tanks to store the oil. The system is clogged. We have an enormous ugly oil glut.

Remember out there are a group of contract holders that must take delivery of the oil products they purchased for future delivery. They don’t want or need it and they don’t want it dumped in their swimming pools. Until the delivery date, they can sell their contracts at ever lower prices. Eventually nobody wants that oil or the contracts. The contracts are worth zero, and owners of the contracts must

pay someone to store the oil. Remember somebody is going to end up holding the bag and be forced to take the oil. The contracts go below zero as contract holders must find someone to pay for the storage.

This is a bad day at the office for speculators and any contract holder forced to sell their contracts below the price they promised to pay. This financial system is somewhat removed but still linked in important ways to the real world.

Prices for the contracts are not directly related to spot prices. The contract may be below zero while next month’s contracts are positive, and spot prices hover around $20 to $30 per barrel.

Meanwhile in the real-world retail customers are still paying their somewhat lower spot price for gas at the pump. Their hearts are filled with joy. However, most of them are not driving much anyway.

In another part of the real-world investors, employees, banks and others are feeling real pain. Predictions are that there will be more than a thousand American producers that cannot pump oil at prices below the world market price. If this goes on many will fail and the impacts will ripple across the financial system.

Oil and gas producers and a huge part of our markets. Additionally, oil consumption is a proxy for economic development. So, as you might expect security prices across the world economy are significant. To the extent that retail customers are celebrating at the pump, they are somewhat less happy when they look at their portfolios. What happens in the oil patch directly impacts all of us.

By | 2020-04-22T20:55:21+00:00 April 22nd, 2020|Blog|

About the Author: