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From Andy's *Home* Office: How can oil go negative??

Andy Michael | April 29, 2020

On Monday, April 20th a benchmark price for a barrel of oil closed at negative ($37.63).

How and why did the price of oil go negative?

First, we need to understand why oil prices were low enough to even go negative in the first place. Oil started the year around $60/barrel for West Texas Intermediate (WTI) – the oil produced in the US. In March, two major events happened – (1) the coronavirus shutdown and (2) Saudi Arabia and Russia's fallout, which led to increased output and lower prices. Demand collapsed and supply increased at the same time! This sparked a steep decline in prices, and oil was trading around $18 on Friday, April 17, which set the stage for the following Monday.

Oil is traded on the futures market with contracts set to deliver each month. WTI oil contracts are settled with physical delivery of oil, while the global benchmark for oil, Brent crude, is settled with cash. As demand for oil collapsed, the US reserves to hold oil quickly filled up, leaving nowhere to store oil set for delivery in May. Traders realized they did not want to actually take delivery of the WTI oil right now and pushed the May contract to negative prices. It's almost like having a junk remover come to your home – you have to pay someone to take the things you don't have room for anymore! Meanwhile Brent crude contracts never experienced a negative price since taking immediate physical delivery of oil wasn't an issue. And as of today, all future WTI oil contracts have a positive value ranging from $12 in June 2020 to over $54 in February 2031! As the economy starts the reopening process while simultaneously oil companies are cutting production, it's possible, but unlikely that negative oil contract prices will occur again.

Is there an opportunity to buy oil or invest in energy companies?

For buying oil - unfortunately not. A contract in the US is for delivery at Cushing, Oklahoma, which is a hub for oil pipelines and storage. And 1 contract for delivery of oil isn't for 1 barrel... it's for 1,000 barrels, which as the New York Times explains, is about 5 tanker trucks worth of oil! And finally, crude oil doesn't have much utility until it is refined into consumable energy like gasoline. The refining and transportation process still have costs, so with that and the tax charged on fuel, don't expect free gas at the pump anytime soon!

For investing in energy companies, the market has looked well beyond the immediate price of oil and is considering the long term recovery of the economy and demand for oil. In fact, from March 29 – April 28th, during the same time the May WTI contract fell below $0, the energy sector has been the best performing sector in the US market! However, energy is still is down nearly 40% in 2020 to date. So, while we believe a small allocation to energy can be appropriate as part of a diversified portfolio, trying to make a quick buck in energy stocks based on the latest oil price is speculation - not investing.

What do low or negative oil prices mean to me?

Here are a few takeaways at how low energy prices can impact you:

  • Immediate savings at the pump with both lower prices and less driving
  • Potentially lower inflation driven by lower energy costs. This means higher real purchasing power and better outcomes compared to inflation assumptions built into financial plans.
  • Lower direct market impact – the energy sector in 2008 comprised nearly 17% of the S&P 500 Index, it now makes up less than 3%, meaning lower direct impact to a diversified portfolio.
  • Yet increased market volatility – when oil spikes in price (up or down), it creates general market volatility as energy is still embedded into the economy with jobs, financial lending, consumer spending, and inflation.

Bottom line - add a brief negative oil price to the long list of unprecedented events to have taken place in 2020.

Andy Michael, CFA
Portfolio Manager

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