How Can The Oil Price Be Negative?

Commodities | Apr 21 2020

The seemingly impossible is easily explained, and the WTI crude price crash into the negative last night is really just a storm in a tea cup.

-Futures price, not physical price, turned negative
-Oil price collapse reflects no further US storage capacity
-All will return to "normal" tomorrow

By Greg Peel

To understand a negative oil price, let's first look at gold.

It is well understood that all the gold mined in the history of mankind is a known quantity, and would fit into an Olympic swimming pool, or something like that. Yet on such a minimal volume of physical metal, gold is one of the most heavily traded commodities in financial markets.

Indeed, it is not unusual for one day's volume of trade to exceed the total volume of physical gold that exists in the world. This is because outside of central bank purchases, and retail purchases of bars and jewellery, the vast bulk of gold trading is conducted in the futures market. A futures contract provides the buyer with the right to take delivery of physical gold at a predetermined price and a pre-determined delivery location at a point in the future.

Except hardly anyone ever does take delivery. Some 97% of open interest in gold futures is closed out ahead of expiry, meaning buyers and sellers settle for cash. A futures contract does not exist until one party buys from another, and ceases to exist when a contract is closed out on sale (or a short position is bought back). Gold has a fundamental position in the investment world, but most investors prefer to own gold on "paper" rather than have to keep gold bars in their home safe.

In contrast to gold, oil is the world's most heavily traded physical commodity, and as we know, more is constantly being produced. Indeed, too much more. Yet as is the case with gold, most oil is traded on "paper", through the futures market, or other products such as ETFs.

Unlike gold, there is no one "oil". In Australia, our petrol is refined, mostly in Singapore, from Tapis crude produced in Malaysia. In the UK and Europe, the benchmark crude is Brent, and indeed Brent has taken over from West Texas Intermediate these days as the "global" benchmark price. WTI is not the only US crude. Oil produced from the Gulf, as opposed to onshore US, is called Louisiana Light.

While gold is an element, and is traded as near 100% pure, oil is a hydrocarbon and crude oil can either have a low relative density (light) or a high relative density (heavy), a low sulphur content (sweet) or a high sulphur content (sour). Oils that are heavy and sour require more processing before they can be refined into petrol et al, but because this can be done, all oils can act as a substitute for another at a price.

And that price is typically small relevant to the underlying crude price, hence while all oils vary in price they don't usually vary much, meaning that one global benchmark price is sufficient as a hedging mechanism. And that's why commodity futures came into existence to allow producers and consumers to hedge their exposures and given the US led the world in the development of financial markets, as well as oil production a century ago, West Texas Intermediate became the benchmark contract, in futures form.

The delivery point for WTI is not even in Texas, it's in Cushing, Oklahoma. When sellers of WTI futures do deliver oil rather than close out for a cash trade, it goes into storage tanks at Cushing until the buyer then does whatever with it, which would mostly be refine it. But storage costs money.

And this point is critical.

Substitution

A decade ago, when oil prices were a lot higher, the gap from the WTI futures price to the Brent futures price widened out to almost US$20/bbl, despite typically being more like US$2/bbl given substitution potential. The reason is the explosion in US fracking and production of so-called "tight" oil up to that point ran way ahead of the storage capacity at Cushing Oklahoma. The cost of storage shot up, undermining the price of WTI crude specifically.

This is about when the market decided Brent was a more viable benchmark.

The irony was that given the US was a net oil importer, oil produced in the Gulf was piped from Louisiana to the Cushing storage tanks for domestic use. The explosion in US oil production swung the US to be a net producer, allowing for oil export, the bulk of which could leave the ports in Louisiana. For various reasons I won't go into here, the US still imports oil, as well as now exporting it. But the point is, the Louisiana pipeline to Cushing was now flowing the wrong way!

As soon as the flow was reversed, the Brent-WTI spread returned to normal.

More recently, in the oil price collapse produced by a combination of reduced demand due to the virus and increased supply due to an orchestrated Saudi-Russian price war, on top of the US already producing too much, had again seen the Brent-WTI spread widen, to as much as US$10/bbl. Again, the issue is that of storage. With airlines grounded, cruise ships docked and not many vehicles on the road, stored oil volumes began to build up and up.

An oil industry expert noted on US business television this morning that all available US storage is now either taken or "spoken for". And that includes filling oil tankers and sitting them off the coast going nowhere.

That's why the expert was none the least surprised the WTI price turned negative.

Get Me Out!

In between the producers and consumers of oil hedging in the WTI futures market are the investors, speculators, commodity funds and sponsored oil ETFs that provide the bulk of liquidity in any day's trading activity, and none of whom had any intention of actually taking delivery of physical oil. As has always been the case, they would simply buy/sell to close out their futures positions before expiry and take their profit/loss in cash, or roll over positions into the next delivery month contract.

The benchmark WTI price is always the "front month", meaning the closest delivery month, and then contracts are listed on a monthly basis thereafter. Indeed one can currently take a position in every month out to February 2031.

The current front month is for May delivery, and expires tonight. When it expires, holders of WTI futures (ie buyers) will be stuck with the delivery of physical oil unless they sell their positions. Aside from a New York hedge fund, for example, not really wanting to end up with a load of crude oil to deal with, oil costs money to store. At some point last night, as the May WTI price fell, it would have passed the cost of storage.

But what is the cost of storage? There is no storage capacity left. Unless you happen to own an oil tanker, the cost of storage is as good as infinite. On that basis, anyone stuck with a futures contract has no choice but to sell at any price. And any price implies you'd pay just to get the stuff off your hands.

Last night the WTI May delivery contract price traded as low as minus -US$40.32/bbl, down -320% from the prior day's price around the (positive) US$18/bbl mark. This is simply a reflection of speculators not wishing to be stuck with oil. Those bailing out of commodity funds or ETFs will have prompted the fund manager/ETF sponsor to themselves sell out, and it is not their mandate to provide a profit, just an investment vehicle to trade in.

The largest listed US oil ETF typically holds some 30% of the open interest in the Nymex WTI contract. However, the sponsor of that ETF is no fool. According to reports they were rolling out of the May contract and into the June contract early in April.

So it wasn't them.

Time will tell if one big hedge fund or commodity fund has now blown itself up, or whether last night's price action reflected a large range of speculative positions among various investors/speculators that could find no buyer given no one has anywhere to store the oil. But what is important, notwithstanding there is one more session of trading tonight before actual expiry, is last night's melee has no impact on the price of physical oil.

Two points to note:

The price of the June WTI contract, which will become the front month on Wednesday night, fell only -15% to (positive) US$22/bbl.

The price of the Brent front month futures contract, which last night was June given May had already expired, fell only -7.5% to US$25/bbl.

The price of oil will continue to be impacted by demand and supply under in the former case and over in the latter and no doubt will soon be impacted by shuttered or abandoned marginal US production and bankruptcies among higher cost, small US producers.

Will we see a repeat performance in a month's time when the June WTI contract approaches expiry? I think the market might now be once bitten, twice shy.

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