What is happening with oil prices and what does it mean going forward?
This week, we witnessed history. The price of oil turned negative and quite literally meant that oil was the cheapest that it has ever been. EVER! Take a look at this chart that shows that the price of oil in real terms (adjusted for inflation), was the cheapest that it has been going back 150 years to 1870. That means that no one alive has seen cheaper oil prices!
While that is a pretty staggering thought, there is a lot to unpack to better understand why it happened and what it means for us moving forward. It is also worth stating upfront that it is not technically correct to say that the ‘oil price is negative’ as was plastered across our TV’s, but we will walk through that in a few moments.
First, let’s talk economics 101 to better understand what generally drives oil prices. The price of oil, just like any other commodity like wheat and soybeans, is driven primarily by supply & demand. That is, how much of a particular commodity exists, and how many people want to buy it ultimately determines the price. In general, high demand and low supply = higher prices and low demand and too much supply = lower prices. Oil prices have been smashed recently on both the supply and demand side.
First, let’s look at supply:
Even before the Coronavirus pandemic, the price of oil had been low and going lower, as the amount of oil produced was more than the world needed. This was primarily due to:
The US oil boom drove the United States to become the largest producer of oil in the world in 2018
OPEC refusing to actively cut and limit production of oil
Saudi Arabia and Russia triggering an oil price war where they both refused to lower production of oil in an attempt to exert pressure on each other, US oil producers and to ultimately gain market share by selling oil at prices that most other oil producers couldn’t match.
These factors played a big role in the oversupply of oil. There was simply too much oil available and prices started to drop. But the oversupply is only one part of the reason for the recent historic collapse. Even if supply is too great, as long as demand is strong, then prices may be lower, but still relatively stable. On the other side of supply is demand.
Oil has been hit extra hard as the demand side of the equation also fell apart due to the Coronavirus shutdowns. Think about it practically. If planes aren’t flying, cruise ships aren’t cruising and people aren’t driving to work, then what happens to the demand for oil? It goes down. I think that I have personally filled up my car with gas once in the last 6 weeks, versus every 2 weeks. My parents didn’t fly back to South Africa for a planned trip last week as the flight was cancelled. Less activity = less demand for the commodity that makes activity possible, which is oil.
We have gone back to basics and have a better understanding of why the price of oil dropped so significantly in recent months and weeks, but how does the oil price turn negative?! Think about what a negative oil price means. It quite literally means that if you had an oil well in your backyard and went through the effort to extract it from the ground, you need to pay me to take your oil, versus me paying you. It is a strange concept.
I mentioned earlier that it is not technically correct to say that the ‘oil price is negative’, but what did I mean? To explain this, I need to get a little further into the weeds, so bear with me for a moment. When the oil price went negative on 4/20/20, that was referring to the price of the May futures contract for West Intermediate crude oil, which was set to expire the very next day. A futures contract is essentially an agreement between 2 parties to take delivery of a physical asset or commodity at a fixed price at a stated date in the future. It is like if you owned a jelly bean factory. Because I love jelly beans, you and I agreed that next month I would buy 1000 jelly beans from you for $10. Now imagine that in the interim, I no longer wanted the jelly beans that I had agreed to buy. I am contractually obligated to physically receive the jelly beans that you have produced, so I need to sell my contract for 1000 jelly beans to someone else who actually wants the jelly beans and will be willing to accept the delivery in a month’s time.
While the illustration may seem silly, this is essentially what happened this week. The May contract to accept 1000 barrels of oil was expiring and the people that had previously entered into the agreement to physically take delivery of the barrels of oil literally had nowhere to store the barrels, as there had been such an oversupply and lack of demand for the barrels that they already had on hand. In simple terms, no one wanted to take more barrels of oil as they had nowhere to store them. How do you get someone to take something that you don’t want? You pay them to do it. A negative contract price essentially means that instead of me selling you my contract for 1000 jelly beans for $10, I literally pay you $10 to take them (the price of jelly beans turns negative).
Note that this does not mean that the price of jelly beans as a whole is negative. While the May contract did go negative, the contracts for delivery in June and further out still have positive (albeit very low) prices. It is certainly possible that as we get closer to the expiration of the June contract that prices may drop significantly (and potentially go negative again) if people still have nowhere to store their oil and oversupply is still rampant, which is likely.
Ok, that’s enough digging in the weeds for now and now I really want jelly beans. But let’s finish this by talking briefly about the possible implications of extremely low oil prices:
Oil prices are generally a leading indicator of economic growth and health. A low oil price generally points to the expectation that economic activity and growth will be slow in the coming months & years. The oil price movements in recent weeks point to a weak economic environment in the future.
Nations that are heavily reliant on oil revenues will be hurt badly, which could lead to increased social unrest.
In the US, the oil and gas industries employ a lot of people. Few firms in the US can operate profitably at these very low oil prices. Low oil prices significantly increase the likelihood of mass layoffs and bankruptcies.
That wraps up this discussion on why oil prices went negative this week and some possible implications for global markets. Please feel free to reach out if you have any further questions. Stay safe and healthy!