This has been another week of historical market moves and our readers will no doubt have seen headlines that Oil traded in negative territory for the first time. Does this mean that we will all get paid to take petrol at the pumps? Unfortunately, not. Let me explain.
When market participants trade the price of black gold, they cannot do so through buying and selling physical barrels of Oil. Clearly, this would be impractical and expensive due to the storage, transportation and insurance costs. Instead, they use a derivate contract called a future. A future is a legally binding contract to buy or sell a commodity on a fixed date in the future, hence the name. Traders who think that Oil will go up in value “go long” and buy a futures contract instead of buying the oil now and storing it until it is needed.
The extraordinary price movement in Oil on Monday was on just one US Oil contract which expired on Tuesday, and several factors converged into a perfect storm for this particular contract.
Markets have been concerned that the demand for Oil will be significantly less due to the dramatic fall in Global economic activity. Further, a brief price war between Russia and Saudi Arabia resulted a large oversupply of Oil globally. Finally, US storage facilities, primarily Cushing, Oklahoma, are almost at capacity.
If you were left long when the contract for May delivery stopped trading, you are legally required to take physical delivery at Cushing. These are binding, legal contracts and holders faced a serious problem; take delivery of the Oil with nowhere to store it (at a reasonable cost) or dump the contract at any price you can.
All of this resulted in a fall in the price of the May future of almost 300%, hitting a low of -37%. This is unprecedented and another sign of the deep economic contraction that the World is facing.
So, whilst the price you and I pay at the petrol pumps will not be negative, the general fear around Oil’s supply and demand dynamics spread into the wider Oil markets through the week and prices have been extremely volatile. A common Oil benchmark price index has fallen over 30% this week and prices a barrel at $16.83 at the time of writing. This is down from around $60 per barrel at the beginning of the year. The following charts shows the percentage change of the benchmark since the beginning of the year:
Whilst a bad sign for the Global economy, lower Oil prices should help the eventual recovery. Not all the price falls will be passed through to the consumer but the price at the pumps should fall, nonetheless. It is unfortunate that this is at a time when we are all staying at home.
The impact of the precipitous fall in the Oil price will be felt most acutely in the Oil exploration and production companies. Many will find their profits decimated or, at worst, their business no longer viable.
This will be felt most in the UK where around 12.5% of the FTSE 100 index is just three Oil & Gas companies, but also in the US High Yield Bond market, of which around 11% are energy companies. Prudent analysis and risk management will be key here.
In other news, researcher at Oxford University announced their intentions to begin human trial of a vaccine for Covid-19 on Thursday 23rd April. Numerous institutions and companies around the World are scrambling to get a vaccine ready as soon as possible but, we would remind clients that an effective vaccine which can be produced in sufficient quantity is likely to be someway off yet.
Until next week, stay safe and well.