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With Oil Below Zero, Are Investors over a Barrel?

04/23/2020

For the first time in history, the price of oil in the US has dropped below zero. On Monday, April 20, the price of a barrel of West Texas Intermediate (WTI) crude for May delivery—the benchmark for oil produced in the States—fell by as much as $58 from the prior trading day’s close, at one point changing hands at a previously inconceivable level of -$40.32 before rebounding modestly to close at a price of -$37.63. The eye-popping -306% fall was also the largest single-day percentage decline the commodity has ever seen. For comparison, the second-largest decline on record was -33% on January 17, 1991—the first day of Operation Desert Storm.


What does this mean for investors in the oil market? We look at what might have caused the decline and expectations for the near term.


What’s behind the oil collapse?

Oil futures contracts are tied to specific delivery periods. The current front-month WTI contract calls for delivery in May and is settled through physical delivery of oil to Cushing, Oklahoma. By US Department of Energy estimates, there were roughly 55 million barrels of oil stored near Cushing as of April 10. This is 70% of the 79 million barrels of total capacity estimated by Morgan Stanley. Furthermore, Morgan Stanley estimates inventories are increasing by nearly seven million barrels every week. By the time the May futures contract requires delivery, storage capacity at Cushing will likely be maxed out. This means that any participant still long the May contract on April 20 and without a storage plan in place was likely forced to sell their position before the last day of trading on April 21, which may have played a role in the precipitous drop.  


In contrast, the price of a barrel of Brent crude—the benchmark for oil prices outside the US—fell only 8.94% on April 20, closing at $25.57 and avoiding much of the selling pressure on WTI. The front-month Brent contract doesn’t mature until the end of April and has an option to cash-settle, which likely means no one was forced to sell their position on April 20 in fear of taking delivery of oil. Furthermore, traders looking to take or make delivery of Brent have more physical locations available versus the single delivery hub for WTI, and those locations aren’t completely tapped out—at least not yet. 


A lack of storage isn’t the reason oil prices have cratered this year but an outcome of the demand destruction caused by COVID-19 and global supply that’s been slow to adjust. Continuing to produce a product that no one can use, combined with having nowhere to put it, is a recipe for disaster.


What does the oil collapse mean for investors?

One thing to keep in mind is that investors in the oil market, whether via ETFs or futures-based strategies, generally avoided the worst of the April 20 plunge. The United States Oil Fund, a very popular ETF among oil investors, fell 10.93% that day, while the Bloomberg WTI Crude Oil Index declined 10.67%. This was driven by the fact that most holders of oil futures contracts roll out of the front-month contract in advance of maturity to avoid taking delivery of the physical commodity and to maintain exposure to the price of oil. Most investors went into April 20 positioned in the June contract or a further-dated maturity.  


Even though most investors avoided April 20’s cataclysmic decline, they can’t avoid the costs of owning physical oil. The price of oil for future delivery is derived from the daily spot price plus any associated costs or benefits to owning physical oil over the specified period. Given that we’re swimming in oil and running out of space to store it, the forward curve has entered what many investors have dubbed a super contango, in which the price for near-term delivery trades at a significant discount to further-dated contracts.  


This is not a normal state for the oil market, which is plain to see when looking at the forward curve from just a month prior in the chart below. If the supply/demand imbalance doesn’t improve over the coming weeks, it’s entirely possible we could see further weakness in the June contract—and possibly even subsequent contracts—as they approach maturity.


WTI Forward Curve

WTI Forward Curve


Sources: CME Group, Bloomberg, 4/20/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.


The bottom line

The price action observed in the futures market for WTI on April 20 may have been exacerbated due to technical pressures as the contract approached its maturity date. But the collapse in prices over the past couple months speaks to the dire state of the oil market in the US and around the globe. Only time will tell how long it will take to work through the growing surplus. One thing we can know for sure is that the market sees further price volatility ahead. The Cboe Crude Oil Volatility Index, which measures the market’s expectation of 30-day volatility, closed at nearly 226 on April 20. This equates to an expected daily move in oil prices of +/- 14% over the coming month.


Greg Liebl headshot

Greg Liebl, CFA, Senior Investment Strategist

Greg drives strategy evolution across Parametric’s Emerging Markets, International Equity, and Commodities strategies. Since joining Parametric in 2010 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Greg has provided portfolio management in the areas of risk and exposure management and customized implementation solutions. He earned a BS in business administration with a finance concentration from North Dakota State University. He’s a CFA charterholder and a member of the CFA Society of Minnesota.

 


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.


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