We saw something this week that’s we’ve never seen before: Oil traded for a negative price. Oil prices have been under significant pressure recently, even before the global economy came to an abrupt shutdown last month.
This week it became crazy.
Not surprisingly, the headlines about the negative price of oil didn’t tell the full story.
To tell the story, we have to start by defining what a futures contract is. A futures contract is a financial product that requires an investor to take delivery of a commodity, in this case oil, at an agreed upon price and time in the future.
It’s usually used by companies and their related industry. For example, an oil producer — who is the one that drills for oil and pulls it out of the ground — may want to use the contracts to ensure that it doesn’t sell it’s future production for too little. An oil refiner — the one who turns oil into gasoline, petroleum and kerosene — might want to make sure it doesn’t pay too much for the oil that it needs. Speculators also use these contracts to make bets on the direction of the price of oil.
On Monday, the May contract for oil dropped from $20 a barrel to -$37 a barrel. The reason for the drop is that the contract was expiring and investors were worried about actually having to take deliver of the oil.
You can think of it as a game of hot potato. Whoever is left holding the contract when it expires actually has to receive the physical commodity. Investors in oil try to make money from daily swings in the price of it, they have no interest in someone actually delivering barrels of oil to their front lawn if they are the ones left holding the contract.
On top of that, they’re responsible for the transport of the oil, which can cost a lot more than the -$37 a barrel that it was traded for. Investors were willing to say they will pay you $40 to not have to worry about this risk and scramble.
Oil and gas consumption is very low right now, as no one is out driving or flying. There’s a glut of oil and no where to store it. If you go back to ECON 101, it’s simply the law of supply and demand.
Naturally, the questions we received this past week on the topic are:
What Does This Mean?
Right now, this upside down pricing for oil is short term. June contracts finished the week at $16 a barrel. When the price of oil is under $30-50 a barrel, it has a recessionary impact on the economy. At $30-50, it’s not worth the big energy companies to drill for it, so they shut down their drilling and exploration projects and lay people off.
The energy industry isn’t as big as it used to be in terms of the overall economy, but there are still 6.4 million Americans employed in it.
How Can Someone Take Advantage of It?
When someone asks us this, we highlight the risks involved in investing in oil or energy companies right now. If you think the stock market is volatile, it’s nothing compared to the oil industry. The price of oil has been swinging 30-40% up and down daily.
It’s no secret that prices are low…. there’s an ETF called USO that was created to mimic the price of oil, but it doesn’t really do a good job of replicating it, even though it is down 79% for the year.
The other way to invest in low-energy companies is by buying stock in one of the big energy companies. While not as much risk as strictly investing in the price of oil, these companies come with a lot of risk as well.
If it takes too long for the price of oil to bounce back, these companies will shut down their projects, cut their dividends, lay off workers and have trouble meeting their bloated debt payments.
The price of oil may bounce back and the stock price of the companies in the sector may come back off of lows, but there’s still a lot of risk so investors have to be careful.
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