What's happening with the oil market?
On Monday, US West Texas Intermediary (WTI) oil cratered to -40 USD a barrel. This isn’t a joke – oil traded in negative territory for the first time in history, just a week after the price was at 25 USD a barrel.
As May's futures contract was about to expire on April 21st, traders exited their trades so fiercely that the price saw it’s biggest collapse in history.
Why is this oil price drop happening?
Firstly let’s understand how oil is traded; oil is traded via futures contracts, which have a one-month expiration. When one futures contract is about to expire, traders usually roll their positions onto the next contract - the most active contract is known as the front-month contract. However, if you’re still holding the contract when it expires, you would have to accept the physical delivery of the oil the contract owned. Let’s paint a clearer picture; if you’ve gone long on futures of 1,000 barrels of oil, when the contract expires, you need to physically take in 1,000 barrels. This isn’t what traders sign up for, unless they’re a company buying oil for use in their business – such as airlines.
Retail traders simply want to be able to trade on the movement of oil prices; they’re not interested in physical deliveries. Therefore, as the expiry date loomed, traders realized they have a huge problem. Either sell now at any given price and accept the financial loss or take the physical delivery and accept a much bigger problem and an immense financial loss as they would have to deal with storing the barrels they bought. So, they dumped their derivatives at any price, some even payed others to take the those derivatives off of their hands.
And this is how we managed to only drop the price not only to $0 but further down into negative prices, for the first time in history.
Still, about 100,000 contracts remained open at the settlement date, meaning physical delivery will be done for 100,000 * 1,000 barrels of oil – which is a huge and unusual volume of physical deliveries. Typically, a much smaller number of contracts is open on the settlement date.
It seems that some traders were unable to exit their positions, or there was no counterparty for buying the futures, or perhaps nobody knows what really happened on Monday.
What's next for the oil market?
According to Goldman Sachs, the same thing can happen again – this time ahead of June's contract expiration.
Many investors and traders are probably spooked by Monday's events, meaning some buyers won’t return so soon. Additionally, there could be another negative side effect and that’s investors rolling their long positions from the June to the July contract later in May.
Finally, we can’t ignore the demand-supply situation which is disrupted while much of the world is in quarantine. While there’s virtually no demand for oil at the moment, global production is still very high, and there’s no storage space left for placing all those barrels.
We expect prices to remain under pressur over the next couple of weeks while the market rebalances itself. When demand returns – potentially during the holiday season, if the quarantine has been lifted by then – oil prices could start increasing in response to increased demand.
For long-term traders, buying financial products on oil at current market prices can be profitable if positions will remain open for months, until the price begins climbing up again.