What Happened To Oil?
A Quick Introduction to Futures Contracts...
It's hard to believe that just a few short years ago, pundits and gurus were talking about the notion of "peak oil." Now, earlier this week, oil futures contracts for the May delivery were trading at negative prices, meaning that you were paid to take possession of the contract. To the non-professional investor, here is a quick breakdown on what futures are and how they work:
- Futures contracts are contracts that establish a buyer and seller of an asset for a specified price in a future date.
- In the case of oil, the buyer of a futures contract can lock in the price of a barrel of oil, which will be delivered on a specific date every month.
- If the price of oil is higher than the agreed upon price for the buyer at the time the contract expires, the buyer can make a profit. For example, if you buy a June 2020 oil futures contract for $20 and the price of oil is at $30 when the contract expires, you make a profit of $10. Conversely, if you buy a June 2020 oil futures contract for $20 and the price of oil is $10, you lose $10.
- If you hold the contract to expiration, you are obligated to take physical possession of the underlying asset, in this case barrels of oil. Not only do you have to arrange for delivery of the barrels, but you have to pay for storage of those barrels of oil and furthermore, if you want to get rid of them, you have to find a willing buyer to take those barrels of oil off your hands.
In many cases, unless you are planning to take delivery of the underlying asset, you can sell your futures contract and exit your position entirely or you can roll the contract over to the next month of expiration.
Now that we have a basic understanding of how futures contracts work, we can talk about some of the dynamics of what happened earlier this week.
Peak Oil to Negative Oil?
The concept of negative oil prices is hard to comprehend. However, given the current landscape, here are some of the dynamics that drove the temporary dislocation in the price of oil:
- The May 2020 futures contracts stopped trading on Tuesday, April 21st, 2020. This is when the price of oil went negative for those contracts.
- The popular oil ETF, USO, owned 25% of the outstanding volume of May 2020 contracts. Clearly an exchange traded fund (ETF) is not going to take physical possession of those barrels of oil, so the fund systematically rolls those contracts over to the June contracts before the expiration.
- Many of the usual buyers of oil futures contracts (think airlines), don't really have a need for huge amounts of oil since most airlines have seen a 90% drop off in flights from just 1 year ago. If planes aren't flying, they aren't using fuel, hence no need for oil.
- This has created a huge supply/demand imbalance. Remember Econ 101?
- Thus, we had the perfect storm for the price dislocation we witnessed on Tuesday, where the May 2020 contracts traded at negative prices.
Is This A Buying Opportunity?
Anyone who is a college football fan knows Lee Corso and also knows his favorite saying, "Not So Fast My Friend!" You may think that with oil futures trading at negative prices, this would be the ultimate "buy low, sell high" moment. Is there a better low price than a negative one? Unless you are a professional futures trader, your next best option to gain exposure to the oil markets would be to buy the aforementioned ETF, USO. However, when you are forced to roll contracts over every month and the futures for your underlying asset are in an environment called "contango", you actually are doing the opposite of "buy low, sell high" and you are buying the asset at a higher price than what the market thinks it will be worth at expiration. When an asset is in "contango" all that means is the futures curve is upward sloping and so buying oil in the future may not be a profitable endeavor. See the chart below:
You will notice that the price of the May 2020 contracts were significantly lower than the June 2020 contracts. USO was forced to sell the May 2020 contracts at a lower price and then buy the June 2020 contracts at a higher price.
Buying the oil ETF, USO, is an imperfect way to gain exposure to the oil markets directly. Many news outlets and financial journalists are hinting that the USO may go away, similar to the short volatility ETF that blew up, after we saw elevated market volatility in 2018. As always, you should consult your adviser with any questions, or feel free to drop us a line at email@example.com.
Gibraltar Financial, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.