A commodity (crude oil) that was once trading at 140 dollars suddenly became so worthless
that you couldn't even sell for free.
On the 20th of April, oil price crossed the zero dollar mark and went as far as negative
40 dollars.
Some people got excited since they were expecting free gas at the gas stations.
Some went as far as imagining that they will be paid to buy the oil, which sounds a bit
strange.
To understand the current crises, we have to have some clarity on how crude oil prices
work in the first.
Like any other market, you would assume that the laws of supply and demand drive the price.
Oil producers on one side such as Saudi Arabia, Russia, UAE, and others.
And a dozen major consumers on the other side such as the US, China, and India.
So if suddenly these countries would no longer want the oil, the prices would decrease and
vice versa of course.
Oil producers can also manipulate the price based on how much oil they would supply the
market.
But here is the problem with the oil market.
Sometimes the demand can rise, but the price drops, which doesn't make sense using the
laws of economics.
And that it because oil prices do not often work with supply and demand but are more driven
by what happens in the financial market.
Yes, those dudes in the wall street with fancy suits quite often have more influence over
the oil prices than oil produces themselves.
This industry is really competitive, and it's not easy to get into it.
You can't simply drill oil under your house and start selling.
It's mostly governments, or government-controlled companies who are producing the crude oil
and risks are high, like really high.
Imagine spending millions of dollars extracting crude oil from your soil.
Then ship it to your client, who is thousands of miles away, and then find out that oil
prices have dropped.
In fact they dropped so low that selling this oil is just unprofitable or worst.
You have to sell it at a loss.
To prevent such things from happening and be confident that regardless of what happens,
the buyer will buy your crude oil at an agreed price, you make a contract.
Let's call it a forward contract, where both of you agree to buy and sell a particular
asset in this case, crude oil at a specific price and on a specific date.
Whether the price of oil increases or decreases, it doesn't matter, the seller has an obligation
to sell the oil at an agreed price, and the buyer has to buy at an agreed price
- The Rich dudes from wall street But on the other side of the sepctrum, there
are speculators.
These are the rich dudes from wall street who are trying to make money by speculating
on the prices by buying and selling futures.
A future is a contract pretty much like a forward contract except its often not delivered.
And it is traded in the market like a stock and base on what’s happening in the oil
industry, the price of the future changes.
Let's say Mark is a trader and wants to speculate on the price of crude oil by entering into
a futures contract in April with the expectation that the price will be higher by September.
The September crude oil future contract is trading at $40 dollars right now in April
and Mark buys the future.
The contract is worth 40 thousand dollars since oil is traded in blocks of a 1000 barrels
(price ($40) x quantity (1000 barrerls)).
Fast forward few months and its September and the end of contract is approaching.
Lucky for Mark, the price of the oil has increased to 52 dollars so the future contract he purchased
for 40K now worth 52K.
So he sells the contract at that price and makes 12K in profit (40K - 52K) but if the
prices had fallen to 35 dollars for example, he would have made a loss of 5K dollars.
Simple, right?!But from April to September, the price of the oil fluctuates so does the
price of this future and Mark can sell it any point.
Futures allow investors to use leverage to trade with oil without physically dealing
with it.
Lets say oil prices are 20 dollars and you expect them to increase next month.
Such a contract worth 20K dollars (20$X1000 barrels) but you can buy such a future for
as little as a $1000 and leverage the rest.
The price goes up to 25 dollars next month, and you sell the future for that price- $25K
($25 price x 1K barrels).
You still owe your broker 19K dollars since you only paid 1K for this contract and you
are left with your thousand dollars and a 5K in profit.
You profited from crude oil without producing it or buying it..
So back in 2001 and 2002, many of these traders speculated that the price of crude oil would
rise since countries like China and India were growing exponentially.
They would need more oil to keep growing, so the demand for oil would increase.
Therefore oil prices kept growing until they reached 140 dollars right before 2008 and
crushed together with the rest of the economy as everyone expect the demand for oil would
fall since there is a financial crisis in the streets.
And since then, they haven't really grown that much since renewable energy is getting
more and more popular and a wide range of other factors.
But that doesn't mean oil is getting worthless.
At least in the next few decades, the oil will still be the major source of energy,
because it is not only used to fuel your car and plane but in almost everything we use
day to day.
If that's is the case, then how did we end up with negative oil prices $-40.
First of all, we had a price war between Russia and OPEC countries.
OPEC is an oil cartel that consists of 12 major oil producers, but Russia isn't part
of it.
However, in recent years, Russia decided that if it would better if it would collaborate
with OPEC.
But then in March Russia decided it won't need OPEC anymore and would better off on
their own.
So the de facto leader of OPEC Saudi Arabia decided to punish Russia for violating the
agreement by flooding the market with so much oil that prices dropped by half.
Traders and speculators were already afraid that oil prices would decrease further and
placed future contracts at a lower price.
And then the Pandemic struck the entire planet.
The United States and other major consumers of crude oil had to go on lockdown.
So with so much oil in the market and with no one to buy it, of course the price significantly
dropped.
Especially future contracts, since their price change daily based on what's happening in
the industry.
But what was interesting is what was happening with futures of WTI or West Texas Intermediate.
Their last day of trading crude oil futures contract was 21.04.2020. which means all the
oil traded under this contract is set to be physically delivered next month, which is
in May, but the country is on lockdown, and the demand for fuel is below the ground.
Since there aren't any cars in the streets and planes are grounded and parked at airports.
In other words, a ship full of oil will be delivered (to US), but there is nowhere to
store it because the United States has seen its oil storage capacity fill up.
After all, airlines and other buyers aren't using nearly as much crude oil as they were
before the crisis, so if the firms with the ability to store it aren't buying it.
Still, you have to do something with it.
You can't simply throw it away or ditch it in the ocean.
So the owners of these futures wanted to get rid of these contracts by selling them as
soon as possible because as mentioned before, they have nowhere to store that oil.
And since no one was willing to buy these contracts, the owners of these futures paid
the buyers who have the capacity to store that oil to take it off their hands so that
they can exist the market.
So what does that mean?
The oil isn't sold for free or at a negative price.
No one would spend millions of dollars to extract the oil and then end up selling it
for free but rather only the demand for futures (CONTRACTS) in the financial market dropped
so significantly that the owners of these futures had to pay the buyers to take off
the burden of storing the oil from their shoulders.
In fact, the negative price has scared off investors so much that the price recovered
the next day.
The futures for the next few months are already higher, reaching even 30 dollars per barrel.
Of course, futures and forwards are a bit more complicated than what we have explored
in this video, but in the middle of so much misinformation, I wanted to provide some clarity
on what exactly negative oil prices mean.
And I apologize that this video isn't on time, the problem with our videos is that, they
take a lot of research and are animated by a different person so the video can take sometime
before its ready to be uploaded.
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