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Oil Prices: A Primer

Like many commodity contracts in the investment world, oil futures trade on a time-based curve. By this, we mean that oil futures contracts have different expiration dates. At the expiration date a contract holder takes possession of the physical commodity. You can buy or sell a contract expiring May 2020, June 2020, July 2020, and so on. The price of each contract typically differs at each expiration date because the demand for oil at a given point in time is neither static nor uniform. This is very important to note, because when you read headlines that cry out “The Price of Oil is Now Negative!”, what this really means is one oil futures contract (in this case the May 2020 contract) went negative. However, when you look at the oil futures curve for expirations beyond May, the prices are all positive.

As we will explain in more detail below, what Monday’s movement means is that extremely near-term demand for oil has declined and the cost to store it, roll the contract into the next month and put the oil in storage was higher than the market price of that oil. Monday’s unique circumstances do not mean the rest of the curve has negative prices.

What Happened to the Price of Oil?
On Monday, the oil surplus in America came to a head as the price of oil went to zero. Well, not really. The May 2020 futures contract on West Texas Intermediate (WTI) went negative. As of this writing in after-market trading (US), the price was around $-16, but this was off a low of around $-37. That is the first time in history you have seen prices that low. Essentially people who had oil to sell had to pay people to take it from them. The price that we find more telling of where the market currently stands is the June futures contract, which is in the range of $16. The positive out of this is that the June contract (and those farther into the year) is showing prices that are more realistic and they are positive.

According to Bloomberg, “Since the start of the year, oil prices have plunged after the compounding impacts of the coronavirus and a breakdown in the original OPEC+ agreement.” With no end in sight, the virus generated demand destruction for the commodity, and producers around the world continued to pump more oil than can be used on a daily basis. This supply demand imbalance has caused a fire-sale among traders who do not have access to storage. Because of this dynamic, the world’s storage facilities are filling up. Compounding this are traders who are mainly financial entities and are either unable or unwilling to own the oil and do not want to deal with finding a place to store it which is getting increasingly expensive. It is this last point that highlights the current conundrum: Storage. Within the United States, there is a dearth of locations available for the physical stockpiling of oil. Until demand picks back up, we could be looking at continued stress in the oil markets.

The NY Times reports, “The problem isn’t limited to the United States. Out of an estimated 6.8 billion barrels of storage in the world, nearly 60 percent is filled, according to data assembled by various energy consultancies. Storage is almost completely filled in the Caribbean and South Africa, and Angola, Brazil and Nigeria may run out of warehousing capacity within days.”
What Are the Long-Term Investment Implications?
For those invested in oil markets, they should be prepared for continued volatility. As 2019 ended, the world was using about 100 million barrels of oil daily, but the Coronavirus has caused the global economy to dramatically slow. According to the US Energy Information Administration, US gasoline usage is down 18% in the last 4 weeks and CNBC is reporting that oil demand is on pace decline by more than 20 million barrels per day. The leading oil producers saw this demand decline, but until very recently have not moved in a coordinated fashion to reduce supply and so with supply exceeding demand prices have dropped.

We could have a deal struck between Russia and Saudi Arabia this week or next that would lead to a curtailment in global supply vs the “false” deal announced last week. That deal attempted to cut production by about 10 million barrels starting in May, with a further 5 million cut from other G-20 countries. However, we are uncertain of the ultimate length of the COVID-19 impact on the global economy, therefore it is difficult to forecast when demand for oil will return to pre-coronavirus levels. In addition, when the global economy starts to re-open for business, the oil in storage beyond normal operating parameters will need to be used before prices really can return to some form of longer-term stability. A “real” deal is needed because until the price of a barrel of oil is in the range of $40, we believe US oil companies will struggle to make a profit.

We think the best thing that could happen for energy markets would be for American life to return to “normal”. With most of America under “Shelter at Home” orders, any return to “normal” seems light years away. While today may have been an extreme, the new reality is that until there is a cut in production from the producers in the energy space (OPEC+ and Russia), the price of oil will be diminished and so too will be the value of it.

The information in this Market Commentary is for general informational and educational purposes only. Unless otherwise stated, all information and opinion contained in these materials were produced by Foundations Investment Advisers, LLC (“FIA”) and other publicly available sources believed to be accurate and reliable. No representations are made by FIA or its affiliates as to the informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. No party, including but not limited to, FIA and its affiliates, assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

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