Why Oil Prices Went Negative – The Oil Price Plunge A Warning to Investors

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Overnight, the price of oil plunged and for the first time in history went negative.

What does that even mean?

Bizarrely, it means some holders of certain oil futures contracts were willing to pay to offload their holdings.

The contract in question expires today and is for a May delivery of the actual oil.

This caused a bit of a rush for the exits as traders who had no interest in accepting physical oil dumped at their door, scrambled over each other to get out of their trades.

The price reached a low point of -$37.63 per barrel.

We’re clearly living in a bizarro world these days. Last year we had the spectre of negative interest rates emerge, and now we have negative oil prices.

It’s a new world of investing, that’s for sure.

As someone quipped on Twitter:

After receiving $35k to take 1,000 barrels of oil, the CFA text book recommends parking the proceeds in a safe, negative yielding sovereign bond.

Paid to take oil and paid to take a loan. What next, paid to buy a house? I wouldn’t be surprised…

Now, such an extreme situation with the oil price has many thinking it could be a great buying opportunity.

After all, it can’t get much cheaper!

But there are a few dangers lurking here that you should be aware of.

Let me explain…

Why oil prices went negative

First up, you need to know what’s going on with the oil market in general.

Now as I discussed yesterday, there could be a deeper story at play.

A story that involves an attempt to put US energy companies out of business, and in turn put the primacy of the USD denominated energy markets into question. It might even be an attack on the US dollar itself.

But conspiracy theories aside, it’s also just a question of supply and demand.

The maths here is quite simple…

The world’s in a global lockdown, so less oil is being used. But a lot of countries that produce oil rely heavily on the revenue, so they’re still pumping out supply.

Oil costs money to store and a lot of storage facilities are reaching capacity. So, nobody who can store it for you will buy it from you.

Which leads us to the situation we’re in now, where you have to pay someone to take it off your hands.

It should be noted that the negative price situation only applies to the May futures contract that expires today.

The June WTI oil contract is still trading at US$20.43 per barrel.

Of course, the June contract could suffer the same fate as May’s if global demand for oil continues to stay low due to global lockdown.

Which is an important point to consider if you’re thinking of investing in oil.

A popular way for investors to invest in oil is through oil ETFs (Exchange Traded Funds).

The problem is in how these ETFs operate…

Know what you’re buying

You see, ETFs buy futures contracts which they then roll over each month into the next month. They never take physical delivery. They’re designed to mimic the spot oil price, but not necessarily reflect it with 100% accuracy.

And the timing of when the ETF rolls over into forward month oil contracts matters a lot for investors.

For example, you might buy into the United States Oil Fund (USO) ETF betting on an oil price rebound.

But then find the value of your holdings don’t go up, even if the spot oil price does. This is because of the way these ETFs are constructed and the effect of rolling over contracts.

As the USO website explains (my emphasis):

USO gets exposure to oil using derivatives, like all oil ETPs. Derivative returns can vary greatly from spot oil prices, but spot oil is uninvestable. USO holds front-month futures contracts on WTI, rolling into the next contract every month, just like our segment benchmark. This method is particularly sensitive to short-term changes in spot prices, but can also result in heavy roll costs.

In this situation the spot price might rise, but your ETF might already be holding the next month’s contracts. And they might not move at all, even if the spot price does.

They might even go down!

It’d be annoying as heck to make a correct ‘bet’ on the direction of the oil price but see the value of your investment fall because you didn’t understand how your ETF investment worked.

Unfortunately, I’m afraid a lot of retail investors are only now finding this out.

Check out this chart showing users’ holdings of the USO ETF on stock trading app, Robin Hood:

MoneyMorning 07-11-18

Source: Twitter @Nic_Carter

[Click to open in a new window]

That explosion of holders has corresponded with the ETF price plunging.

Avoid the wipe out

There are some industry commentators suggesting that this is going to get worse as the lockdown continues and storage facilities continue to max out.

See this tweet for example:

MoneyMorning 07-11-18

Source: Twitter @AndurandPierre

[Click to open in a new window]

You’re talking about investors’ entire capital being wiped out in these ETFs if this happens.

But as ever with investing, there’s always the other side of the coin to consider…

Maybe, oil is a bargain right now and we’ll see prices tick back up with a vengeance as lockdown ends and the global economy gets back on track later in the year.

If that’s what you think, be careful to find an investment that you understand. Certain well picked energy stocks might represent a better bet.

We’re living in strange days, that’s for sure…

Good investing,

Ryan Dinse,
Editor, Money Morning

PS: In this free guide, discover how a currency crisis could drain the supply of circulating cash…and how you can keep your standard of living when going through it. Download the free guide now.

About Ryan Dinse

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately…

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