For the week ending on April 24
We saw the headlines earlier this week: “Oil Prices Go Negative”, “Oil Crashes”, “Oil’s Sub Zero Plunge”. While later in the week, headlines transitioned to “Oil Rallies More Than 50% in Two Days” and “Oil Prices Extend Rebound.” What does it all mean and why is it such a big deal?
First, it helps to understand how oil is actually traded. While there are 160 different types of crude oil traded, the benchmark in the U.S. is WTI Crude, or West Texas Intermediate (the crude oil from U.S. wells). Oil primarily trades on futures contracts (see below for Term of the Week), meaning that there is an agreement to physically deliver a set quantity of oil at a fixed price and date in the future. Each contract trades for a month, and the May contract expired on Tuesday.
- Traders who buy these futures contracts always sell before the end date of the contract, when physical delivery would happen – no investors really want to be stuck with thousands of barrels of oil. (1 contract = 1000 barrels)
- Typically, there is never a need to take delivery as there are plenty of oil buyers, such as airlines and refineries. But now, with such low oil consumption, there is already a ton of excess supply.
- Adding to the issue, traditional oil buyers who could otherwise have been enticed to buy cheap oil are quickly running out of storage space.
On Monday, with one day before oil would be physically delivered to investors holding WTI May contracts, we witnessed the price of the oil contract fall below zero…well below zero to -$37.63. Essentially, investors who did not want to wind up with 1000s of barrels of oil actually had to pay buyers to take supply off their hands before the contract expired! Crazy enough, if you had owned a tanker and had lots of storage space, you could have been paid a lot of money to pick up oil in Cushing, Oklahoma (the contract delivery point and the heart of the U.S. pipeline network)…and simply sold when prices moved higher.
Negative prices were a big deal since this has never happened in the history of the oil futures market, but it is not reflective of the actual situation. To better capture what is going on, you need to look ahead a few months – at June WTI contracts (which expire on May 19), and even July and August. Each successive month is now showing higher prices, meaning that the market is expecting oil prices to increase in the future. Regardless of what forward month you look at, one thing is clear: the price of WTI is extremely weak, and it is all due to simple economics – the law of supply and demand.
- Supply: OPEC and its allies did agree to cut production by 10 million barrels a day beginning on May 1, and Kuwait may even start cutting earlier than May. But this is only 10% of production – meaning 90% is still being produced.
- Demand: Until we start driving more and flying again, demand will likely stay quite low for some time.
Both sides of the economic equation are impacting price, and until we see either lower production or more travel, expect oil prices to remain low for some time.
As for the stock market – the main indexes ended the week lower – but in much better shape than the dismal economic data would indicate. Yes, another 4.4 million Americans filed for unemployment benefits this week. But, thanks to the $484 billion supplement to the CARES Act (including $321 billion to further help small businesses) and oil trading higher from historic lows, the week ended on a more positive note.