Negative Oil Prices

The nationwide shutdown in response to the coronavirus has hit all corners of the economy, including the energy sector. The oil market made historic moves on Monday with the headline price of crude oil falling into negative territory for the first time. How could this happen? In short, suppliers continue pumping oil, while the demand for oil has plummeted. All the while, we are running out of storage capacity, and having to find creative ways to store it. Ocean tankers can hold oil offshore, but as demand for oil tankers rises, the price to rent a tanker keeps going higher. This is the crux of the issue.

For a little bit of context, the International Energy Agency (IEA) estimates that global demand was roughly 100 million barrels per day prior to this downturn. And suppliers were able to meet that level of demand (and more if needed). With shutdowns around the world, people aren’t commuting, airlines have cut flights and businesses have temporarily shuttered. Because of this, demand for oil has fallen sharply – by about a third according to some projections. But suppliers haven’t stopped production by the same amount. This is what is known as a “supply glut”. Although this decline in demand is likely to be temporary, it creates significant challenges for the industry.

How does the price of an asset go negative?

Investing in the oil market (and other tangible commodities) is different from investing in the stock and bond markets. Whereas a share of stock represents a portion of a company’s future earnings stream, an oil futures contract represents the ownership of 1,000 barrels of oil which will be delivered to you later. When monthly oil futures contracts expire (usually around the third Tuesday of the month), millions of barrels of oil will be delivered within the next week or so.

For this reason, most buyers in commodities futures markets are companies that need physical oil (or a derivative, like gasoline) on a future date (e.g. airlines, shipping companies, chemical companies), and most of the sellers in these markets are companies that provide physical oil (e.g oil producers). These market participants typically use these contracts to lock in prices and hedge against the potential for unexpected future price fluctuations. However, over the years many hedge funds and institutional investors have also been investing in oil futures – participants who are not looking to take physical delivery of the commodity.

Because demand is so low right now, the recipients of all those barrels of oil will have to find a place to store it for the future. Since many storage areas are filling up, the price to store oil has risen. The increased cost of storage was being reflected in the price of oil as a negative price for the futures contract. Effectively, a negative price meant that the seller of an oil contract (e.g. a hedge fund which needed to sell before expiration) would pay the buyer to take physical delivery of the oil so they wouldn’t have to.

How does this impact long-term investors?

For those who are properly diversified, the energy sector now accounts for only 2.6% of the S&P 500’s market capitalization, as energy stocks have been under pressure ever since oil began to fall in 2014. Going forward, even large swings in energy prices and energy stocks will have a much smaller impact on overall index values.

In general, cheaper energy prices are a positive for U.S. consumers and the overall economy since lower energy prices reduce the cost of products and services both directly and indirectly. Of course, these positives mask the challenges faced by individuals and businesses who directly and indirectly work in the energy industry. While the negative price of oil has captured the attention of investors and headlines, the longer-lasting implications will depend on how quickly the economy gets back on track. Long-term, diversified investors should seek to stay disciplined and see through these temporary developments as the coronavirus crisis evolves.