Mind on Money: Paper oil, real oil, and ‘negative’ prices.

Mind on Money: Paper oil, real oil, and ‘negative’ prices.
By: Marc Ruiz Last Updated: May 4, 2020

Ask me a week ago, and I would have said it would be hard for the world to get any stranger than it has been over the past two months. But Monday morning, the world once again went deeper into the rabbit hole when headlines blaring “Oil Prices Turn Negative” greeted us during our morning routine.

How in the world can the price of oil turn negative?

Well first, let me say I am not a commodities expert. Oil is, of course, a commodity, and as a commodity, it trades actively in the futures market. Futures markets are complex and no place for the inexperienced, so I am going to try to avoid going deeper into the mechanics of how futures trade, but unfortunately, in order to discuss oil, we do have to wade a little into this complex topic.

The first thing to understand when discussing oil prices is there is “paper” oil and there is “real" oil used to make gas and plastic and other products. Paper oil is represented by futures contracts, which trade in active, volatile, and leveraged markets. It is true oil futures contracts, or paper oil, actually control real oil, but a futures contract for oil will be traded many more times than actual real oil ever will. Sometimes trading in paper oil and delivery of real oil-based on futures contracts collide in the real world, and this is what happened with oil prices recently.

It’s no surprise the demand for oil has gone through the floor during the COVID-19 quarantine. Using myself as a frame of reference, my beloved Ford F-150 typically goes through three big tanks of gas a month as I am driving kids to school, going to the Y, and commuting between offices. During the work at home month of April however, I have used about a one-half tank of gas, so one-sixth as much as usual, and I, of course, am not alone in this regard.

Because of the nature of oil production, however, just because Marc isn’t driving his 15 mpg truck around the Region, doesn’t mean all the oil wells can be capped and shut down. Wells in production will continue to produce, begging the question: where does all the oil go if not into my truck?

The answer is into pipelines, tankers, and ultimately storage, all of which are finite in capacity, and very soon that capacity will be completely filled if we all don’t start driving again.

Which is where the paper oil comes back into play. Ultimately, if a speculator owns an oil futures contract, they are in reality obligated to take delivery of the oil when the futures contract expires. Ordinarily, futures contracts can be “closed” before delivery, preventing actual physical delivery of the contracted oil, but because of futures contract exchange traded funds (ETFs) being widely traded by speculators, a supply/demand dislocation between futures contracts and real oil occurred and the oil futures contracts could not be closed.

If the paper oil futures contracts actually resulted in the physical delivery of real oil, there was no place left to store the oil, so the holders of the futures contracts had to essentially pay a counterparty to take the right/obligation to delivery of real oil off their hands, resulting in a negative oil futures contract price.

While I’ve tried to simplify this subject, I will be the first to admit it remains strange and confusing.

So, bottom line. Are negative oil prices based in the real world? Only a little, this is mostly a paper phenomenon related to oil storage. Are these prices sustainable? No, the market will correct, likely quickly. Does this mean free gas? Of course not, I would be surprised if gas prices go much lower. Is low priced oil a screaming investment opportunity? In my opinion, not really. I think oil has lots of systemic structural challenges, I wouldn’t touch an oil price ETF, and futures trading is for sophisticated, experienced traders only. Oil company stocks, while more attractive, will likely experience headwinds for many years. I’m sitting this one out.

Opinions are solely the writer's and are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing involves risk, including loss of principal. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.