Oil Prices Turn Negative, What is Going On?!?

The news that oil prices turned negative is surprising and concerning, to say the least. Here are some thoughts about this situation and where it might lead. One disclaimer: I’m not a commodities expert so this might be a bit rudimentary for some of you. But for the regular lay person, I hope this helps you get a sense of what is going on with oil.

Supply and Demand
Prices are set by the intersection of supply and demand. The quickest way to get to an understanding of price movements is to think about what is happening to each side of this relationship. As I understand it, what we are seeing right now is the result of a huge unprecedented drop in worldwide demand crashing up against an intentional surge in global supply.

The primary driver for the global oil supply is the interplay between big oil producers, whether countries or corporate conglomerates. Countries that organize together (OPEC), conglomerates (like Exxon or BP), or newer extraction companies (like shale oil extractors) sometimes play well together and are able to coordinate output to maintain high prices. But often these players get in spats and standoffs, sending prices haywire. The Saudis have access to huge oil reserves that are cheap to extract, so they are often the player that has the most ability to manipulate output, and thereby global prices.

Demand for oil is driven by overall global economic activity. Cars, trains, planes, office buildings, and factories all use more oil during boom times and less during economic downturns. Recession can put downward pressure on oil prices. For anyone who buys oil or gas, cheaper prices can be good. For the industries that sell oil and gas, low prices are bad since they have to sell their product for less.

So Why Did Oil Prices Crash?
In recent weeks, we had shocks to both the supply and demand side of the oil price equation. Saudi Arabia and Russia got in a fight and weren’t able to come to agreement on output and production. As I read it, in order to punish Russia (and US shale oil producers) the Saudis increased supply a lot. They have played this game before, causing price pain for everyone for a time before they return to lower output and support of higher prices.

Problem is, this time around there was also an unprecedented demand shock. The closing of the economy due to the coronavirus pandemic has caused a widespread stoppage in demand by most all users, all at once. The combination of the two forces: big increase of supply due to Saudi gamesmanship and evaporation of demand due to global shutdowns, cause unprecedented downward pressure on prices. This is the most likely explanation for the recent collapse in oil prices.

So Why Did Prices Just Turn Negative?
The massive global supply chain for oil was never designed to deal with an immediate stoppage of demand for several weeks. The mechanism for oil pricing occurs in the futures markets. Traders in commodities like oil buy and sell based on what they expect may occur in the future. It’s like locking in a price for your heating oil in a one-year contract – might turn out to have been a good or bad idea, depending on heating oil prices over the year ahead.

Oil futures contracts, as I understand it, roll out monthly: one-month contracts, two months, three months, and so on. A trader that owns a contract when it comes due must theoretically take delivery of that oil at the previously agreed upon price.

But what if you have nowhere to put the oil you just bought?

It’s like if you threw a party and no one came. That is what just happened. Supply was recently boosted and demand fell off a cliff. The tank farms, pipelines, underground storage facilities, and tankers throughout the world have been filling up with unused oil to the point of near capacity. The traders who owned contracts expiring yesterday likely realized this and did not want to take delivery of oil. So they rushed to sell their contracts, even give them away, even pay people to take them. And when you pay someone to take something off your hands, you have a negative return on that investment. In short, there’s way too much supply, and very little demand.

What Happens Now?
Prices for longer term contracts, such as three or more months out, are reportedly higher. This means that traders don’t yet see this as a permanent situation. When demand begins to pick up, this glut is likely to slowly alleviate. This can act as a buffer against inflationary pressures. The stock market will likely convulse as it tries to understand this decidedly not normal occurrence. And economic numbers continue to look anomalous and historic.

The economic numbers coming out on all fronts will continue to be generationally awful, so long as the economy stays home. As cities, towns, and states begin to reopen, and demand tentatively begins to build, we are likely to see growth reemerge.

Reopening will be like early spring when the crocuses in the yard seem to come up way too early. But these early crocuses are durable and know what they’re doing. And before long other plants emerge and there’s a full-on riot of growth.

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