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| Chart from forbes,com |
Actually no, not really..
What did go below zero was the price of an expiring futures contract for West Texas Intermediate (WTI) Crude Oil.
So what is a futures contract? I think it is best not to delve into that in too much detail for now because it's probably too much to chew on for a single blog post. Since what we are more interested in is why its price went all the way to negative, perhaps it is best to just focus on characteristics and features of a futures contract and what this means for its price.
Perhaps the most important thing we need to know about a futures contract for now is that it is a financial instrument that, for the most part, reproduces the financial consequences of owning the underlying asset, which is to say that to own a crude oil futures contract gives one the risks and rewards of actually owning crude oil. For the most part.
What happened last April 20 was actually a "squeeze" on one particular crude oil futures contract, the May 2020 WTI crude oil contract. A squeeze is a concept that should be familiar to all of us - it is the reason why a bottle of water usually costs so much inside amusement parks, because the seller knows we absolutely must buy it, and he knows he is the only source. It works in both directions. When the buyer of a used car, for example, knows that the seller absolutely needs to sell (perhaps because he desperately needs the cash), he will usually give a very low offer. "Babaratin", in the vernacular. Call it human nature or greed, whatever it is, it is usually assumed to be an instinctive and natural tendency.
Now let's introduce you to some features of a futures contract that came into play last April 20:
A futures contract has an expiry date. Upon expiry, the holder/buyer of a crude oil futures contract must accept delivery of the actual crude oil. The seller has the obligation to deliver. It is actually this mutual obligation to deal the underlying commodity in its physical form that ties, or tethers, the price movement of the futures contract with the price movement of the actual commodity. If that last sentence is a bit difficult to visualize then its okay, what's important to note and remember is the fact that as a particular futures contract nears expiration, the buyer in that contract has two options: one, he can wait for expiry and take delivery of the oil, or two, if he does not actually want the oil, he should "trade out" of the contract (i.e. sell it in the futures market) while it isn't yet expired.
When one party holds a lot of open contracts near expiry, and it is well known that he does not have the ability to take delivery of physical oil, then he is in a particularly vulnerable position, because the other market players know that his only real option is to trade out of his positions before expiry. Aware of this urgency, the other market players can now squeeze him. Pwede na syang baratin.
Apparently, it's no big secret that last April 20, such a market participant did exist. Since I have no personal knowledge regarding the matter I will not talk about the identity of this participant, except to say that this participant owned a lot of open contracts, and was a purely financial player (i.e. did not have the competence to take delivery of physical oil, which must be delivered in a only a certain form, to a specific number of accredited storage facilities in the US) And so, the squeeze was on.
Knowing that this participant absolutely had to trade out of his contracts, other knowledgeable market players bid only very low prices, knowing that no matter how low or even ridiculous your bid, a trader who is under severe time pressure, and therefore urgency, and even desperation, to trade, will still need to hit your bid. Last April 20 the squeeze was so successful that the price actually turned negative - this meant that the seller was actually paying the buyer to take the contract off his hands - which actually makes sense given the scenario we just described.
So what happened last April 20 was actually not oil prices going negative, but the price of the expiring oil futures contract turning negative, due to what is probably one of the most successful squeezes of all time.
Now, the really interesting lesson in all of this is why this particular squeeze was so particularly successful. There are expiries of crude futures monthly, and surely, this is not the first time a market player had to trade out of a long position near expiry. So, why this time, did prices fall off a cliff and go underwater? Why not all the other times?
The answer does indeed lie in the extraordinary conditions the world finds itself in because of COVID-19. With more than half the world population locked down inside their homes and businesses closed, demand for crude oil has gone down a lot, warehouses are full, and therefore there isn't much demand left for physical crude oil. In more normal times, with normal, healthy demand for physical crude, a market player looking for buyers of futures contracts at just 20% lower than the last traded prices would have found so many buyers from participants who could just hold the contracts to expiration and take delivery of oil bought at 20% lower than market prices. Last April 20 those participants were taken out of play, or neutralized, because their storage capacity was already full. The market player who had a bunch of contracts to unload thus found himself at the mercy of much fewer remaining buyers.
This does not mean that the price of crude oil itself has turned negative. If crude oil really had a negative price. One could drive a truck up to a crude oil storage facility and gladly been given crude oil for free. The owner of the oil would be eager to give it away for free, since a zero price is better than having to pay you to drive away with it. This was, I believe, certainly not the case last April 20. I don't know that for sure, but I seriously doubt it.
Another way to think of the situation is this - under normal circumstances, the price of the futures contract is indeed very much a representation of the price of the physical oil. To emphasize in the clearest terms - a buyer of physical oil can wait until a futures contract nears expiry, buy the futures contract, and receive oil tomorrow or at most, a few days later. So he would have gotten a free lunch if the price in the futures contracts were cheaper than the price in the physicals, and the laws of financial physics preclude such free lunches. So prices in both markets are thus effectively tied to each other. But when this link between the physical world and the financial world has been broken (e.g. There is no appetite for new transactions of physical oil because the storage tanks are bursting), then what keeps the prices in the two worlds in lock-step with each other has effectively been broken, and thus the price in each of the two worlds become free of each other.
On April 20, the price of the futures contract effectively lost its connection to the price of physical oil, and thereby took on a life of its own. With a sharp imbalance in supply in demand, or perhaps more accurately, with a sharp imbalance in the urgency of the supply and the urgency of the demand, prices took a wild and perhaps unprecedented turn.