COVID-19: Negative oil prices

Earlier this month the futures price for a barrel of West Texas Intermediate (WTI) crude oil for delivery in May at the New York Mercantile Exchange (NYMEX) dropped from over $10 to below zero. In fact, at times the futures were trading below -$40, meaning the buyer of one barrel of oil would receive not only the oil but also a cash payment from the seller on top.

There are three key steps to understand this negative price. First, it is crucial to note that the instrument examined is a futures contract, i.e. a contract to buy or sell an asset at a predetermined price at a specified time in the future. This means traders can enter such a contract without physically owning any oil. The seller is only required to deliver physical crude oil to the buyer (physical settlement) if the position is not closed before expiry, which in this case was the next day, 21 April 2020. Therefore, futures can be used for hedging and speculation purposes by market participants without any interest in purchasing the underlying asset, in this case crude oil.

Second, the lockdown following the Coronavirus outbreak has caused a steep decrease in the demand for crude oil, the resource for petrol or kerosene production. While the supply of crude oil has also decreased, it has not declined quickly enough. Even the agreement of OPEC+ to reduce production by 9.7 million barrels in May and June, was not able to stabilise prices.

Third, the futures contract for WTI at NYMEX states that physical delivery shall be made in Cushing, Oklahoma, a landlocked hub with storage facilities already filled to 70% and the other 30% leased out. The upshot of this is that it is difficult to store oil at Cushing right now.

Altogether, traders with long positions in May futures were facing a major problem. They were about to receive physical delivery of oil at Cushing on the next day with no spare storage facilities for the commodity. In order to close the long positions, traders desperately started lowering the price to the point that they were willing to accept a negative price.

While the U.S. produces most of its crude oil for domestic consumption, the other two major oil producing countries, Saudi Arabia and Russia, are exporters of oil, maintaining ports and pipelines to other countries for global distribution, and not short of storage. Therefore, the price fall for WTI futures was not mimicked by Brent futures, the global benchmark for crude oil.

It should be mentioned that extreme volatility and liquidity issues are not uncommon for futures contracts close to expiry, which is why most market participants prefer to close their position prior to expiration. That this phenomenon was unique to the May contract of WTI, is further evidenced by the fact that the contract for delivery in June stayed above $10 over the same time period. Moreover, while it has been the first time in history that the crude oil futures price dropped below zero, this phenomenon has been observed in other markets where storage capacities are limited. The prime example is the market for electricity, where storage is virtually impossible. However, this event has emphasised the importance of storage information for commodity prices. It remains to be seen what will happen on 21 May, when the June contract expires…