Last Monday, something weird happened. Prices for crude oil in the US went to negative $37.63. That means that if you were taking delivery of oil, the suppler would have been paying you to take it. How could this happen? How could something that is still being used around the world be deemed as an actual cost on the world market.
The consumption of oil has fallen dramatically due to Covid 19. Never mind how fewer cars are on the road, airlines have cancelled thousands of flights around the world. Despite this, Russia refused to reduce their oil production in order to keep prices at a moderate level. Saudi decided to flex its muscles and actually increased production to drive prices down further. This was nothing more than a game of chicken between two of the world’s biggest oil producers. And with all this extra oil and less consumption, storage space is near capacity.
Meanwhile, in the US, the more expensive shale producers simply can’t afford prices to be driven down in order to make a profit.
When you trade in oil, you don’t actually take ownership of big tankers of oil. It’s all done through “futures”. This is where you agree to exchange a set amount of oil at a set price at a set date.
Importers and exporters can use them to insure against future price volatility. Traders can also use them to speculate on oil prices without actually having to own any oil. The prices of the futures will move as the value of increases and decreases. The trader can sell the future before it expires and take advantage of the difference in the buy and sell price.
Futures are trades on exchanges, just like stock. But unlike stock, you are not buying ownership in a company. They are traded in the form of oil benchmarks. The two most popular benchmarks are Brent Crude and West Texas Intermediate (WTI).
When the oil war caused prices to fall, investors piled into the biggest ETF, the US Oil Fund (USO). It went from 145 million shares to 1.4 billion, becoming such a big player that it owned 25% of all May and June futures.
The May futures expired on 21 April. If you hadn’t sold by then, you had to take delivery of the oil at 1,000 barrels (158,987 litres) a contract. Now we know that traders are capable of taking actual delivery of oil!
USO was mandated to invest in the most current contract and then roll over into the next one. When all the extra money piled into the May contracts, the prices increased. But as they sold all these contracts, the prices fell and the June and July prices increased.
Now USO hold a lot of June contracts and there is a fear that this will repeat. To reduce this risk, USO has moved to buying some contracts that expire later in the year.
When investing in oil and other commodities, you are not actually buying oil, but oil futures. Add in Covid 19 depressing oil consumption, oil storage facilities at capacity, possible US bailout and Russia and Saudi fighting to be top dog, you are certainly taking a big risk in doing so.
If you have any questions, drop me an email at steven@bluewaterfp.ie