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What...Negative Oil Prices! How Does an Oil Well Work Backwards?

Here is a great article and explanation from my colleague Nell Sloane about negative oil prices. - Erik Long

Negative Energy Prices for Oil

Since the idea of negative prices for oil is perhaps even more perplexing than negative interest rates, I thought I would attempt to explain what’s happening and how this area of the economy works for those who are interested. I also wanted to make sure no one was running to the gas station hoping to make money by filling up. :) Negative values for either interest rates or the price of oil is not exactly a common occurrence, and there is not a lot of space devoted to the topic in finance books (at least not yet).

Oil is bought and sold primarily through futures contracts. An oil futures contract is simply a legal agreement between an oil producer (ExxonMobile, Chevron) and an oil user (Boeing, Tesoro). The oil producer agrees to pump and deliver 1000 barrels of oil for a certain price at some future date, and the user agrees to buy the oil at that price on the future date. Once that contract is in place, it can trade on a futures exchange just like a stock and its price will move up and down as the “spot price,” or today’s price, of oil moves up and down. Someday, the futures contract expires and whoever is the last person holding the contract is the proud owner of 1000 barrels of oil.

A lot of people trade oil futures (and corn, sugar, gold, currencies, etc) and have no intention of ever owning oil. If a trader owns a contract that’s about to expire, they need to sell that contract to someone who actually needs the oil and perhaps buy a contract that still has a month or two to go. This is called “rolling the contract.” The May contracts expired today (4/21), so yesterday was the last day to roll contracts. For the first time ever, traders (or companies that were just hedging oil prices) tried to sell their contracts but no one needed any more oil. Uh oh. “Hey, anybody need some oil? Anyone? OK, tell you what, I’ll just give you the oil. Anyone? How about if I pay you to take this contract?”

When a contract expires, the oil producer is ready to pump 1000 barrels to Cushing, OK, where most of the oil in the U.S. is stored (it doesn’t actually get put into barrels). The receiver of the oil needs to have booked storage space at Cushing, but Cushing is running out of room and all the space is booked. So now what? As a last resort, the oil producer will need to keep the oil in their own temporary storage tanks. To avoid overflowing the tanks the producer needs to slow down production, and that costs money. How much? Apparently, about $37 per barrel, which is how negative oil got at one point. This is not the real price of oil. It is simply a matter of no one wanting more oil yesterday or having any place to store it. As I’m writing this, the June contract for oil is $11.40 (still incredibly cheap, but positive), and the November contract is $27.50.

How does this affect investments, or does it at all? It all depends on how long it takes to get the economy started again. Oil producers will be slowing down production significantly in May, but we have more cheap oil stored than we know what to do with. No one can make money with oil below about $30 per barrel, and most U.S. oil producers need oil to be closer to $40 (Russia needs it to be around $60). The price (and profitability) can rise quickly if producers cut production (which they are) and the economy fires back up, but if the current environment lasts more than a few months there will likely be some bankruptcies among the weaker energy companies. The first bankruptcy, by Whiting Petroleum, has already happened. Energy producers are large users of debt, so stress in the energy markets creates problems throughout the credit markets, not just energy-related. I was recently asked who benefits from these low oil prices, and the answer is really nobody outside of maybe some hedge funds. Normally, airlines would benefit from low energy prices, but in this case oil prices are low in part because airline flights are down by over 90%, so even airline companies would rather have higher oil prices if it means they have customers.

It's difficult to paint a rosy picture about negative or severely depressed oil prices, so I won’t try. At the same time, it’s not necessarily detrimental…yet. As with all areas of the investment world right now, there is a lot more that we don’t know than what we do know. Therefore, it is not obvious that energy is a great investment right now even though prices are historically low, nor is it obvious that current investments related to energy are going to collapse. Banks and other lenders are not interested in owning energy companies, so they will probably delay debt payments and give their energy-related borrowers every chance to get back on their feet. And the world continues to need oil. Hopefully, a lot more oil in the near future than it does right now since oil and global economic activity are inseparable. In the meantime, I hope it is helpful to at least understand what’s going on, even if it’s difficult to make predictions, especially about the future. A lot can happen between now and then.

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