On April 20th, 2020 something happened that has never happened before in history. The price of a barrel of WTI oil for the May contract went negative and closed at -$37.63 for a barrel. But what exactly does this mean and why did it happen?
It’s Not As Simple as Just Supply and Demand
The price of oil is usually determined by supply, demand, and market sentiment toward the product. With the entire global economic situation suffering from shutdowns to combat the coronavirus outbreak, the demand for gasoline has drastically reduced and looking forward is expected to remain that way for at least several months. The supply of oil which is used to refine into gasoline as well as other energy sources has been increasing to unprecedented levels. There is only a limited amount of storage capacity available globally for this oil and due to the scarcity, the price has drastically dropped this year. On April 10th, the market went negative because traders capitulated based on the fact that it is cheaper to pay to have the oil hauled away and stored than it is to build more storage capacity or to shut down the wells that are producing it. So, with this historic market event, where do we go from here?
The Unprecedented Impact of Coronavirus
Moving forward, it is likely that many of the states will begin to reopen their economies. Other countries will also resume economic activity. How long this will take is speculative, but one thing that is certain is that the dramatic drop in price is evidence that the coronavirus has dramatically impacted the global economy, and it is going to take some time for the prices to recover. It is likely that some oil and gas companies will go bankrupt if this downturn in economic activity and oil persist. President Trump announced that the US would open up the strategic oil reserves and ask permission to buy up some of this oil and take advantage of the low prices as well as attempt to stabilize the market. It is likely that oil prices could continue to go down or stay down until the global economy resumes at or near “normal” levels. While it feels good to fill up our tanks for less than $20, it is not always a good thing for the overall health of our economy.
How Does It Impact Investments?
There are more liquid investments on exchanges that attempt to track the price of oil such as USO, which tracks West Texas oil price, and BNO, which is tied to the Brent Crude oil price. It is important to know that they are investing in futures contracts of the commodity, and are not always able to take advantage of the drastic price swings. They are risky investments and complex in nature because of the rolling over of the monthly futures contracts and there should be significant due diligence done to understand the underlying risks of the investments before they are considered.
There is a lot that goes into the market for oil and it is certainly a worry about the impact that it will have on the economic recovery. In the 1980’s there was a drastic drop in price and it took 7 years for prices to recover. Understanding the underlying reasons why oil prices fluctuate are important for investors, but it does not mean that you should necessarily take significant actions.
Where Will The Price of Oil Go From Here?
As it has in the past, prices are likely to stabilize in the future. The economy will open up, and people will get back to work. The future will be determined by the tremendous global economy that has been built and grown on innovation and adaptability and there is no reason to believe that will not be the case this time either. In the meantime, go for a drive (safely and observing social distancing of course) and enjoy these low gasoline prices while they are here!
Disclosure Note: The discussion of oil and ETFs such as BNO and USO are illustrative in nature only. You should check with a trusted professional advisor before implementing any of these investments into your own portfolio.