by Brad Houle, CFA
Executive Vice President
On Monday, for the first time ever, the price of oil contracts for future delivery fell below $0 to -$37.63 per barrel. While financial markets have adapted to the unfortunate reality of negative interest rates, a negative price for a physical commodity is another issue. How this happened is due to two factors that culminated into the perfect storm for oil markets.
In March, Russia and Saudi Arabia, which are among the largest producers of oil in the world, were in the midst of a price war. A pact by OPEC to limit production has been ignored by both countries resulting in record volumes of crude oil being sold into the market. Both Russia and Saudi Arabia depend on oil revenues to keep their economies afloat. The price war in oil and overproduction alone is an extremely disruptive event for the oil markets. Then the virus hit.
As the world economy was slowed to a halt in an attempt to contain the virus, demand for oil fell off a cliff, exacerbating the issue of the excess global production of oil and upsetting the futures market. The futures market is a financial market whereby oil producers can hedge the prices of the oil they sell into the open market. In addition, it is a market for speculation by investors. Monday, April 21 was the contract expiration for the May oil contract. Said differently, it was the day that the buyers and sellers settle up and trade money for the physical delivery of oil for a predetermined price. The greatest limitation and difficulty: the ability to physically store the commodity. Oil tanks were largely full and there was no availability for any additional oil. As a result, delivering oil to buyers became a liability as evidenced by the negative price: you had to pay someone to take oil off of your hands. Currently, oil is being stored not only in remaining oil storage tanks but also rail cars and on ships. For now, the price of oil remains low at around $20 per barrel and negative pricing seems to be over.
Check Your Rearview Mirror
Year-to-date, the stock market has declined a bit over 13 percent, down more than 17 percent from the high on February 19. To most investors this probably feels like a far worse market decline than it has been, most likely due to the whiplash peak-to-trough with the more than 33 percent decline by March 22, followed by a sharp recovery. Along with the stock market volatility, interest rates have dropped substantially this year. The 10-year U.S. Treasury bond was at 1.9 percent at the beginning of the year and has dropped to .60 percent due to the investor flight to quality. Capital markets have been a rough ride this year and we expect to see more volatility. That said, we do not see prices returning to the March 22 lows.
Week in Review and Our Takeaways
The negative price of oil this week was an anomaly and we are not expecting persistent negative oil prices
Capital investor perception of the market decline is most likely worse than what has been actually experienced