Oil prices take a dive, and Equity Guru tells you what it all means

April 20, 2020
oil

As if 2020 has not been weird and unusual already, today the world experienced another unprecedented wacky event:  negative oil prices.  If anyone reading this is about to rush to the nearest gas station to get paid to fill up their tank, think again. I already tried that and it didn’t work.

A more in-depth look shows that North America was the main victim for this unprecedented and historic oil price drop, with West Texas intermediate crude (WTI), being the poster child of today’s travesty.

The WTI future contracts for May delivery which are set to expire this Tuesday fell more than 100% to negative $37.63 per barrel currently. The producers have to literally pay the traders to take the oil off their hands. However, these prices are by no means a good reflection of global oil prices. In fact, even the June WTI contracts, which expire on May 19th, are priced at $20.43 per barrel.

First, some definitions:

Futures

According to Investopedia:

“Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.”

 In this case, we are talking about commodity future contracts. Commodities futures are agreements to buy or sell raw materials at a specific date in the future at a particular price.

Delivery month

Each futures contract has a delivery month. The different months represent when the contract will be exchanged for the physical commodity.  In our example, the May Delivery future contracts for WTI are set to expire Tuesday April 17th 2020.  Any trader holding this contract at the time of expiry will be subject to delivery of the physical commodity in May.

Front and far month

Lastly, futures contracts with a nearby expiration date are referred to as “front month”. Contracts that have expiration dates that are later than the front month are called “far month”. In our case the future contracts for June and July would be far month contracts.

So how did we get here?

1. The virus (lowering the demand)

November/December 2019

First there was a bat. Then the bat was put in a soup. Someone in Wuhan China ate the soup and got sick. Next thing you know, the whole city was feeling sick. They called it the coronavirus.

Jan/Feb 2020

Coronavirus (now renamed COVID-19) began to spread rapidly across the globe. Countries began to prepare for lengthy shut downs to slow the spread. Donald Trump, prepared by playing a couple of rounds of golf and calling it a hoax.

March/early April

Most countries across the globe have closed their borders. They have also shut down their economy and all businesses that are not considered essential. Italy, France, Spain, and the USA are some of the countries hit the hardest with COVID-19.

With demand for oil being close to the lowest it has ever been, the prices have taken a dramatic hit.

2.     The oil price war (increasing the supply)

On March 8th 2020, Saudi Arabia initiated a full-on price war with Russia, causing a 65% quarterly fall in oil prices.

By this time, the pandemic had ground the global economy to a halt, and that coupled with oversupply caused by the price war, meant a severe toll on oil prices.

With barely any planes in the sky, cars on the road or ships in the sea, the demand for oil has never been scarcer. The oil industry is now facing a temporary crisis more powerful than its usual foe, Greta Thunberg and the emergence of renewable/green energy.

 3.     Lack of storage and ETF play

If you were wondering why oil prices suffered the most in North America today, this is why:

“The United States Oil ETF, USO…owned 25% of the outstanding volume of May WTI oil futures contracts as of last week.  With that contract set to expire Tuesday, the buyers of that “paper oil” have to sell or take physical delivery at the end of May,” according to Jim Collins in a Forbes.com article.

But if USO is an ETF, or an exchange traded fund, then how the hell are they supposed to take physical delivery of any oil, let alone 25% of oil from WTI in May? Long story short – they aren’t.

Consider this from Tyler Durden of Zerohedge.com

“A physical contract such as the NYMEX WTI has a delivery point at Cushing, OK, & date, in this occurrence May.  So people who hold the contract at the end of the trading window have to take physical delivery of the oil they bought on the futures market.  This is very rare. It means that in the last few days of the futures trading cycle, (which is tomorrow for this one) speculative or paper futures positions start rolling over to the next contract. This is normally a pretty undramatic affair. What is happening today is traders or speculators who had bought the contract are finding themselves unable to resell it, and have no storage booked to get delivered the crude in Cushing, OK, where the delivery is specified in the contract. This means that all the storage in Cushing is booked, and there is no price they can pay to store it.”

Big OOPSIES

But guess what?  June’s future contracts expiring in May might be affected similarly if the demand and storage issues remain the same.  

What does all of this mean for the economy?

Historically, sharp declines in oil prices have been a saving grace for the economy. Struggling economies have regained their footing on the back of low oil prices. It’s cyclical. The economy is doing great and oil prices start creeping up, and then a crash happens. With less money being spent everything slows down and demand for oil decreases. Oil prices plummet, which often helps an economic rebound.

This was very evident in 2008. The economy crash resulted in significant decrease in oil demands. Oil prices fell from $133 to $40 a barrel, which was potentially a major catalyst to the rebound and growth of the economy in 2010.

In 1986, The Organization of the Petroleum Exporting Countries’ (OPEC) inability to control supply led to oil prices dropping by more than 50%. An event widely believed to be responsible for a surge in global GDP growth, peaking at 4.6% in 1988, a rate that has not been achieved again to this day.

Today’s price drops are different. There was no global pandemic threat in 2008 or 1986 or any other time that low oil prices have caused economic growth rate. According to a report released by International Monetary Fund (IMF) in July of 2019, the expected estimate for the global GDP growth in 2019 was 2.9% and 3.4% for 2020. The IMF’s latest report in April of this year has that figure at -3% for 2020.

Positives

All time low oil prices are not sufficient to provide a quick turnaround for the economy. No one was expecting them to do that anyway, and if you were, please stop watching Trump’s daily briefings. COVID-19 is not the flu and will not go away when the weather gets warm. Social distancing measures will most likely be around for the foreseeable future.

I totally forgot this is supposed to be the positive part.

Never in the history of sciences or medicine has there been such a strong sense of urgency to combat a disease. The global curve is slowly flattening, and besides a few idiots (I’m talking to you toilet paper hoarders and #fakevirus people), society has done an excellent job obeying the living parameters placed upon them.

In their July 2019 report, the IMF’s expected global GDP growth was estimated to be 3.4% for 2021. This figure has now been changed to 5.6%, something we have not seen since the early 1970’s. The insanely low oil prices might not result in immediate economic growth, but its effects might not be as far as originally expected. We hope so at least.

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