Can I take a barrel of oil home?

Today was a historic day. Many of us were shocked by the dive that the price of the WTI had, dropping to negative territory. Some people might have asked themselves “Would I get paid for taking some of those barrels home? Let's try to answer that question by exploring basic principles and rules of the oil market. 

• WTI benchmark definition: West Texas Intermediate (WTI) crude oil is a specific grade of crude oil and is used as one of the main benchmarks for pricing oil. This specific oil grade comes mainly from the Permian basin, from which it takes its name. Most of it is sent to Cushing, Oklahoma, where the delivery and price is settled.
• Distribution and storage capacity: Around the globe, crude oil is sent to different exchange markets where it gets distributed or stored. Distribution can be made by pipe, train or ship; and storage can use tanks or ships. Cushing is limited because it is in the middle of the US mainland, thus the distribution and storage are restricted to land alternatives.
• Global oil demand: Demand is low because people are demanding less of it. Coronavirus has played its part. Most of us are in quarantine in our homes, limiting our activities and limiting our normal purchases. Given this, stores are demanding less of its inputs so less of it gets transported from their origin. Long story short, the lockdown measures have reduced the demand for oil around thirty percent (~30%).
• Supply price war: the increase in production of crude from the US Oil & Gas exploration sector in the past years has pushed the Russian and Saudi Arabia governments to take radical steps to fight for global market share. So, they used their spare capacity to increase oil production, which caused a significant oversupply in the global market. Although there have been talks and agreements in OPEC on cuts on the production, it has not had a sufficient effect.
• Contracts: Companies that use crude as input (e.g. refineries) need to secure their supply in advance. Therefore, the common practice is to commit to future contracts with producers in which they agree to exchange a certain amount of oil at a certain price. To facilitate this process, exchange markets have predefined contracts for every month (e.g. May, Jun, July, etc.) which fluctuate in price according to the supply and demand of a particular contract. On a certain day, the contract needs to be settled (3 business days before the 25th of each month*) so the contract holder receives the commodity at a certain price. Therefore, what we called WTI price is actually the price of the closest contract to be settled.
• Contract settlement: Future contracts are publicly traded, so investors can buy and sell them. The rules say that you have the obligation to receive the delivery of the commodity, if you hold the contract at the settlement day. Therefore, if an investor does not want to be burdened with the physical commodity, he has to unwind (sell) his position on the contract before the settlement day.

What happened today? As oil prices dropped due to low demand and oversupply during the last couple of months, companies stored crude oil in order to sell it when the price recovered. This puts a strain on limited storage capacity, especially if the sea is far away (like in the case of Cushing).

Let's talk about the oil future contract. The May ‘20 oil futures contract settles on April 21st, so the investors who did not want to take possession of the crude started in the last days to unwind their positions. Unfortunately, and for the first time in many years, there were no takers for that oil: the demand dried up due to the lack of storage or use for the oil. Therefore, the price started to tumble and when it got close to low one-digit past midday, the CME Group Inc. announced that future prices would be allowed to go negative. The price reached minus $37, before it crawled back and plunge again. What a day!

What now? Although the prices of the following futures contracts dropped significantly (e.g. June ’20, July ’20, etc.), they remained stable above US$20, a sign that investors expect that the unbalance between supply/demand will be sorted out during the coming month. Nevertheless, if the following contracts’ prices drop as well, it can cause the same accelerated unwind effect we saw today.

What to expect? Hard to know and hard to predict. There are high hopes that demand will start to pick up as developed countries start to reduce their Coronavirus contingency measures once there is a light at the end of the tunnel of finding a vaccine or a reliable treatment. Lower prices will push some of the US production out of the market and we expect further production cuts by major producing countries (e.g. Russia, Saudi Arabia) or the implementation of US government economic policies supporting US oil producers (i.e. tariffs, import restrictions, etc.).

It is too early to think that the economy will recover any time soon. The record unemployment and the damage in the small business sector will put most likely the US economy in a recession for the rest of the year. Also, the Coronavirus crisis might relapse as contingency measures are removed or during the next autumn.

Should we take home a barrel of oil? Although it might be good timing to be in the crude storage business; I would still not consider the right time to take home a barrel of oil yet.

* If the 25th calendar day is not a business day, trading terminates 4 business days prior to the 25th calendar day of the month prior to the contract month.