Blog/Fossil Fuels,Oil & Gas

A quick explanation of recent oil price volatility and why it turned negative…

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We have recently seen the heaviest falls in the oil price in living memory from nearly $57 at the start of January for a barrel to – $37.63 on 20 April. The explanation is simple. There is too much oil supply out there, not enough demand (who’s flying?) and not enough storage capacity. In that type of environment price falls and that despite reductions in supply thanks to the recent OPEC+ agreement. However, it is not as simple as that as many producers of oil (and buyers such as airlines), hedge their pricing going forward, using financial derivatives, meaning they sell or buy it at an agreed price to someone in the future. This is done because it enables a buyer or seller of oil to better plan for the future, or so the theory goes. These complex financial instruments work every well in stable markets but what is clear is that they are part of the reason we have so much oil price volatility today.

Many US oil producers are hedged for this year or a large part of this year meaning that they have sold their products at agreed prices to buyers or they have used financial derivative products such as options and futures to do this. Many of these prices are around $50 which means that they are going to keep pumping oil of the ground and even pay people to physically take that oil. Now eventually what happens is that the hedge expires and then those oil producers will stop producing (because they can’t cover their costs) and the market price returns to some form of equilibrium.

However, much of the oil that is traded is not ever delivered. It is in fact paper oil and in particular so called futures. There are future contracts in place for each month and it was the recent May WTI contract which fell into minus levels. Under that future the owner of the contract on the day of expiry (April 21st) had to deliver oil at the last price of that day to so the called settlement point which is Cushing in Oklahoma which is home to 24 pipelines, 15 storage terminals and 90 million barrels of storage capacity. The issue though in the days coming up to delivery was that there were no buyers for that physical oil as storage facilities and pipelines were full.

To make matters worse though is that there are oil exchange traded fund (ETFs) in place which allow investors to buy oil futures. Many of these have taken in massive amounts of cash in recent weeks as investors seek to buy ‘cheap oil’. These EFTs are set up to never take delivery of the oil but instead to keep investing in paper oil and they do this by always putting their investment capital into the oil futures of the month ahead. This is called rolling the contract and involves selling the old contract (say May) and buying the next one (June). That type of selling only worsens the situation, hence the negative prices and the recent positive bounce in June oil prices. One of the biggest is United States Oil Fund, or USO which recently announced a shift in their strategy to relieve pressure on the June WTI futures to spread the risk among even more forward months. More specifically their allocation is now: June: 40% down to 20%, July: 55% down to 50%, August: 5% up to 20%, Sept: 0% up to 10%. This may reduce oil price volatility, but we will not see till the next roll period which is on the 5-8 May whether it is enough to keep oil prices above zero. On the other hand, it is an enormous opportunity for anyone in the tanker business noting that an oil tanker may hold as much as 2m barrels…

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