Negative Oil Prices? My Thoughts
Another example of the financial news emotions industry spreading misinformation…
Everyone knows it by now. On April 20, 2020, we experienced negative oil prices for the first time in history.
Or did we?
First, let’s review. (Bear with me – we need to get through some basic stuff before answering that question. Skip these paragraphs if you’re an old hand at this.)
A barrel of crude oil is 42 gallons of sticky, stinky, black stuff.
A futures contract, on the other hand, is a contract between two parties obligating one of the parties to sell and the other party to buy a specified quantity of a specified item on some date in the future. The buy/sell transaction takes place subject to certain delivery procedures specified in the contract.
If someone enters into a futures contract but doesn’t want to go through with the buy/sell transaction, that person can offset his position by entering into another futures contract on the opposite side. There is a clearing house that keeps track of all this stuff, and if you have both an obligation to buy and an obligation to sell, the clearing house simply wipes it off the board and you’re good.
A futures contract has an expiration date. If you’ve entered into a futures contract and haven’t offset it by the expiration date, you are obligated to execute the buy/sell transaction.
The details of how futures contracts are priced and how P&L is calculated is largely unimportant to this discussion, except for the following. First, many futures contracts have daily price limits, which limit the range of prices at which transactions can occur during a given day. If there are no buyers above these limits or no sellers below these limits, trading ceases until buyers or sellers come into the market or until the next day. These limits are generally removed as the moment of expiration draws near. Second, at the moment the futures contract expires, the futures contract price and the price of the physical item should converge.
So Did Crude Oil Prices Actually Fall Below Zero?
So, did “crude oil prices go negative” on April 20? I doubt it. Let’s ask the question this way: Was there any place in this country where I could have backed up my truck or tanker car or hooked up my pipeline and said, “Load her up, boys, I’ll take all you’ve got and you can pay me for the trouble!” I’m not a physical oil trader and definitely not an expert on the physical oil market, but if there was any place in the US where I could have been paid for taking away some oil, please educate me.
There were no negative oil prices on April 20. There were negative futures prices, but that’s a different thing altogether. Oil is sticky, stinky, black stuff. A futures contract is a legal and financial instrument that doesn’t even exist except on paper and in computers.
The price of the May ’20 crude oil futures contract went negative on April 20, not the price of crude oil.
The May ’20 contract was scheduled to expire the following day, April 21. Because demand for crude oil had fallen dramatically and storage was scarce (and expensive), buyers were also scarce. There were some market participants who had long futures positions and were thus going to be obligated to buy physical crude oil if they held the contract to expiration.
Some of these participants, however, cannot take delivery for one or more reasons. So they needed to offset their positions at any price. It’s a classic situation, but instead of a short squeeze it was a long squeeze. The futures price had to keep falling until they found buyers to relieve them of their positions. And it turned out that the futures price required to get buyers back into the market happened to be negative.
I was as surprised as anyone when I first heard that the futures price for a commodity had fallen below zero. When you think about it, though, it makes sense that futures prices can go negative. Some commentators have claimed that the exchange should disallow negative commodity prices. That’s nonsense. If the exchange were to disallow negative oil prices, it would be equivalent to setting a daily limit price of zero. What if expiration is approaching and there are no buyers at a price of zero? The result is that you force people with long futures positions to take delivery. That would be a disaster – even if all market participants could financially handle it, do you really want a bunch of quants who know nothing about physical markets to be forced into taking delivery?
Note that there is only a single time when futures prices and physical prices are expected to be the same – that is the moment the contract expires. The rest of the time, we expect there to be a difference between the two prices. Sometimes the difference is large, sometimes it’s small. Increased volatility around expiration is certainly nothing new. Does it really matter whether the futures price is positive or negative? No, it doesn’t. P&L works the same either way.
The following day, April 21, the May ’20 contract expired at a price of $9.06. Yes, getting there was messy and not exactly orderly. But we got there. And the price wasn’t negative.