Oil Prices - A quick explanation and why derivatives can matter
As you most likely will have seen in the media the price of some oil became negative for a brief period. The purpose of this note is to explain what has happened and its significance.
Whether directly or indirectly the oil price can affect us all. Directly because we use fuel in our businesses (transport, heating, as a raw material) or indirectly because our customers and suppliers have similar exposures. However, it is true to say that the market price and the price we pay as consumers are only loosely and distantly correlated.
What has happened: a type of oil known as West Texan Intermediate (WTI) dramatically dropped in price to become negative for the first time in history. Why this happened? In short over supply and lack of demand. This is partly due to the drop-in demand for fuel oil due to the Corona Virus pandemic and partly due to structural problems in the oil industry.
The reason why WTI became negative was also impacted by its physical state and how it is traded. In the USA most physical onshore oil is stored in Cushing Oklahoma, but storage capacity is limited here. The way oil is often traded is for a specific quantity (measured in barrels), of a specific quality (such as WTI) and most importantly for a specific delivery date.
In the current market anomaly WTI for delivery on 5th May was the issue. Due to lack of demand there would be no storage space for this dated oil. The way the commodity contracts are constructed are forward contracts for physical delivery, so when the contract matures you are obliged to take delivery. The contract owner being responsible for delivery and storage costs. There are traders who buy and sell oil contracts and never take delivery, so when Cushing was unable to store it, the traders were desperate to avoid being responsible for the delivery and storage of several million barrels of oil, hence were effectively paying other market participants to take delivery.
Of course, there of ways of avoiding this problem, for example buying an option rather than a forward contract. Derivatives can have a place in preventing millions of barrels of oil turning up in your garden!