Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

How the heck did we get negative oil prices this week and what does it mean for other commodities?

Many of you may have been very surprised to turn on the financial news or even your evening news to see that the West Texas Intermediate (WTI) crude oil price closed negative on Monday. How can oil be worthless, one might wonder. Can I get my gasoline at the pump for free? We wish, although most of us are sheltered in place and are limiting our travels to the absolute essentials and our gas tanks are largely full.

So how can a commodity trade with a negative value? As we are all aware, COVID-19 has altered life as we know it, and the economy has ground to a complete halt. As such, hydrocarbon demand has fallen dramatically. Although the OPEC plus agreement attempted to curtail supply, it was simply not enough to match the demand destruction, and inventories have built to historic levels over the last several weeks. The problem has quickly become storage availability as facilities begin to approach what is known as “tank tops.” Given this dynamic, we can offer some perspective on what happened next.

WTI crude is directly connected to physical and settlement of the futures contract requires physical delivery.[1] The delivery point for the contract is in Cushing, Oklahoma, where, because of Bakken and other crude production from the mid-Continent, storage has been building particularly rapidly and storage space was largely allocated. When the contract came up for expiration and there was not a place for these barrels to go, this forced liquidation as speculators (traders) did not want to take delivery. What it means, in essence, is that you are paying someone to take these barrels off your hands. Exacerbating the problem were so-called “value buyers” who saw the cheap front month crude relative to a very steep contango, or front month discount to forward contracts for the same commodity, and attempted to capitalize on what they perceived to be an anomalous market. We observe that at negative $37 crude, there was limited trading volume, and only 9,900 contracts traded below zero, or roughly $175 million in notional value – effectively there was no significant liquidity relative to the size of the market at those negative prices. So, it is a market dislocation, but one that is very real. If you had to pay to truck or otherwise move these barrels to someplace where they might be needed (i.e., a refiner), it would not be an economic arbitrage and the discount to zero reflects the aforementioned costs.

An obvious question is, do we face the same issue when the June futures contract becomes close to expiration, and we believe that answer to be yes. Although producer well shut-ins are becoming more of a factor in terms of curbing supply, it will not likely be enough to balance the market given where demand is likely to be. We are starting to see rigs being dropped more aggressively. This week alone, the domestic land rig count is down 60 and at 465, down an incredible 70 percent from March 13 of this year as the current crude price hovers right around cash costs. But ultimately as the June contract comes close to expiry and it is apparent that there is no place for it to be stored, we would expect the same dynamic to occur. If there is a silver lining to all of this, it is that the worse the situation becomes, the healthier the industry will ultimately be going forward. Creative destruction is often a painful process and it is no less true in the case of energy.

As an aside, negative commodity prices are not a new thing. We have seen natural gas and other commodities trade in negative territory historically for largely the same reasons we have discussed as they relate to the crude market in the present day. But a key question this brings to mind is, could this possibly happen in other commodity markets? For many of our readers, gold is of particular interest. Unless crude oil, which can fluctuate from a backwardated market to one in contango, gold generally spends most of its time in contango, and therefore, a small amount of negative roll yield (the amount it costs to roll to the next month’s futures contract) is typical for the gold market and is the reason that a positive gold lease rate (GOFO, or Gold Offered Forward Rate) exists. More importantly, however, some gold futures contracts, although not all,[2] unlike WTI crude, although allowing for physical settlement, can also be settled in cash[3] – eliminating the physical delivery problem and the storage problem such as the one we saw at Cushing this week. So it is important to understand the terms of the settlement contract and not just the underlying supply/demand fundamentals to understand why this dynamic might exist. These market anomalies and disconnected markets are merely another symptom of the global liquidity challenges that we face today.

Best Regards,

David McAlvany
Chief Executive Officer
MWM LLC

[1] https://www.cmegroup.com/content/dam/cmegroup/rulebook/NYMEX/2/200.pdf

[2] https://www.cmegroup.com/trading/metals/precious/faq-gold-enhanced-delivery-futures.html

[3] https://www.cmegroup.com/trading/metals/precious/gold-futures-and-options.html