*My explanation of the “Crude Oil” price crisis that has developed over the past 4 months*
You will all have now seen the news, heard people talking about it and are probably wondering how you can make money from it… yes, it’s the 2020 Crude Oil Crisis. In this blog post I will explain in my own words, how the crude oil market has come to be in its current situation where this current month’s futures descended in to negative pricing. I will also explain to you the different financial products used for trading the crude oil markets and why the news headlines don’t exactly tell the whole story.
Let’s start from the beginning, January 2020 when Crude Oil was briefing trades at $65 per barrel and the coronavirus pandemic was only just beginning.
As you can see on the quite dramatic chart shown above, the past 4 months has seen the price of Crude Oil FUTURES (important for later) fall from highs above $60bbl in to negative pricing of nearly -$40bbl. Yes that’s correct, if you bought May 2020 Crude Oil futures yesterday evening you would have been paid (received) $35.60 per barrel. More on the reasons for this later.
So why has Crude Oil been in a free fall?
The first reduction in the value of crude oil from January through to March was caused by a slowing in Demand. Firstly, China closed its manufacturing sector due to the outbreak of Coronavirus over there. China is the second biggest consumer of Oil so when they shut down, demand falls hard.
All financial markets are governed by the laws of supply and demand. I have talked about this multiple times in previous blog posts but once again I shall show you a basic demand and supply graph to explain.
The graph above shows what happens to price (P to P1) when demand for a commodity decreases from D to D1. When demand decreases, price decreases and this is what happened to Crude Oil through the first quarter of this year.
However, as coronavirus continued to spread across the globe and the international shutdown of almost all economies and industries began demand for commodities and more importantly crude oil, decreased further – much further.
Planes aren’t flying, people aren’t driving their cars or riding their motorbikes, train services have been reduced and public transport usage has approximately halved in the UK.
Wait there is more…
To increase price, and keep it semi-stable when demand is causing a decrease in price, you can simultaneously decrease supply. If you use the same demand and supply chart shown above and draw an imaginary S1 line parallel to the left of the S line you will see that where it now intersects with the demand line, price is actually higher.
From the highs on January 8th 2020 to the close price on Friday March 6th 2020 (2 months) the price of Crude Oil fell by over $23bbl. That equates to a decrease in price of approximately 36% in 2 months.
Over the weekend commencing 7th March 2020, the OPEC deal that was intended to cut Crude Oil production (reduce supply) fell through. Saudi oil producers refused to reduce production and actually slashed their crude oil prices even further by up to $8 per barrel for their customers. This led to Russia also refusing to reduce production and the creation of what is now being called the 2020 Russia – Saudi Arabia Oil Price War.
The chart above is annotated to show you the 2 main bearish waves in crude oil futures prices prior to this weeks dramas. The first drop in price, as explained, was caused by the first signs of lack of demand from the coronavirus spreading, this caused a drop of around 34% through 2 months of trading. Travel bans coming in to place, flights being cancelled and China shutting down production.
The second drop shown on the chart above was much quicker and violent. This was caused by the beginning of the price war, Saudi Arabia slashing prices and the fallout of the OPEC supply deal. As you can see, this second drop in price was over 58% in under 1 month of trading.
Negative Oil Prices!
Some of you keen eyed readers will have noticed that the price charts above show the price of Crude Oil as negative and that is correct. Last night (April 20th 2020) the price of May 2020 WTI futures went below $0.00. This is the first time in history Crude Oil futures have ever traded below zero.
In layman’s terms, this theoretically means that if you were to buy 1 contract (1000 barrels) of Crude Oil futures that expired today (on the 21st April) at the price shown on the charts above, you would receive $35,600 and 1000 barrels of Oil would be delivered to you soon unless you managed to sell the contracts on which is very unlikely because no one was buying.
Why are suppliers paying to give oil away?
Put simply, there is such low demand and supply has not decreased enough to stop crude oil stocks at storage locations from reaching near full capacity. The chart below shows this.
Therefore no one wants to take delivery of crude delivering this coming month because there is no use for it and no where to store it. This means a huge lack of liquidity in the crude oil futures markets and that lead to the sharp selling in price seen recently.
Even more crazy is the spread between futures contracts. Yesterday, whilst May futures were trading at almost -$40bbl, the next months futures contracts (June 2020) were trading above zero at around $25bbl. A difference of $65 per barrel for simply waiting 1 month to take delivery of the very same Crude Oil that they were trying to pay to give away.
Imagine you are selling your house and you must move out on Friday. You have a buyer ready but suddenly he says you must pay him £400,000 for him to take it and move in this week. Or if you can wait 1 month, he will pay you £250,000. That was the current situation with near expiration Crude Oil futures.
Crude Oil isn’t really worth less than zero!
Although the near term futures set to expire today are priced negative, Crude Oil is not worth less than zero dollars. As explained previously, the same Oil to be delivered 1 month later is worth more than $14bbl today and more than $30 if delivered at the end of the year. The image below shows the various futures pricing and spot price for both Brent and Crude Oil so you can see this for yourself.
This is purely a logistically dilemma and over supply and low demand that has caused a very short term over exaggerated drop in Crude Oil prices. Crude Oil indexes such as the Bloomberg Crude Oil Subindex is still trading above zero with levels of volatility much lower than the near term futures contracts (see below).
What does the future hold?
In my opinion I believe we will likely see production cuts come in to play from Russia, Saudi and the USA very soon to help to reduce the over supply. The Trump Administration has already committed to helping the oil industry with stimulus which is no shock.
Long term there is going to be no real gains made on the price of Oil until humans get moving again. Travel bans need to be lifted, manufacturing and other industries open again and demand needs to return. When this happens were should begin to see some good returns from Oil related products.
There is a very real possibility that, unless we see big production cuts and some sort of sustained increase in demand, the June 2020 Crude futures contracts will also break below $0.00bbl and in to negative pricing.
My long term view (3 years – 5 years and beyond) is that Oil will return to previous price levels seen at the beginning of this year and higher. I do not see renewables taking away the majority of normal demand levels for Oil/fossil fuels happening in my lifetime. For that reason I would be buying Oil related indexes and products at these levels purely based on the upside potential vs downside risk ready for when we remove lockdown restrictions and normal demand levels return.
I will not be buying near expiration futures contracts because as explained, they still have a real risk of going negative again. ETF’s (exchange traded funds) are the easiest way for an individual to buy in to cheap oil for the long term. They have lower costs, lower volatility and great potential compared to spread betting futures, spot prices or CFD’s.
THIS IS NOT FINANCIAL ADVICE! Please don’t go and buy Oil financial products because of any of the information listed in this blog post.
The current financial markets are operating in unprecedented territory and acting in ways never seen before. Oil futures trading below zero for the first time ever is serious and shows how much of an effect coronavirus has had on the world but unfortunately there is not a lot we can do except stay safe, listen to the experts (not karen sharing fake news on Facebook) and weather the storm.
I will leave you with an eye opening statement. At least 5 wars have been fought and thousands have died over a commodity and natural resource that has ended up being worthless and given away.
All my technical analysis is done using the TradingView platform. You can get access via the link below.
My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.
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