Oil Price Crashed below $0 – What does this mean and how to invest?

Yes. This is not a typo.

It is the first time in the history that oil price is trading at a negative price!

Many of you would have questions about how this can happen and how to buy oil and benefit from it.

How could this happen?

Oil price is based on a financial instrument known as futures contracts. A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future. Futures contracts are traded between producers and buyers all around the world and are crucial for the workings of our economy.

Reason #1 – Low global demand due to COVID-19

Given that the global economy is pretty much in a standstill due to COVID-19, the demand for oil is expected to be lower than the supply. The world consumption was around 90 million barrels a day while the production was 100 million barrels per day by the end of the first quarter of 2020. That’s a surplus of 10 million barrels a day. Prices have to come down when there’s oversupply.

Reason #2 – Storing oil costs money, and storage is running out

Excess oil has to go somewhere if not consumed. They end up in storage and oil storage is not free. Crude oil is stored in salt mines, tanks and oil tankers. In fact, HIS Markit already sounded the warning in March, saying that the storage will run out by the first half of 2020. This is because there are 1.6 billion barrels of storage capacity available while inventories will increase by 1.8 billion barrels. There would be no space left to store oil and producers are paying buyers to get rid of their holdings.

Reason #3 – ETFs could be unwinding the futures contracts

The negative price that we have seen, is specific to May 2020 delivery for WTI Crude Oil (produced in the US). Other contracts were trading normally. Brent crude oil (produced in the North Sea) contract expiring in May 2020 was trading over US$20 per barrel and did not crash. Also, WTI Crude Oil contracts expiring in Jun 2020 onwards were trading above US$20. Hence, the negative pricing was very specific to May 2020 WTI Crude.

The finger was pointed to United States Oil ETF (USO). The ETF doesn’t take physical deliveries of crude oil and will always rollover the contracts before they expire. USO was claimed to own 25% of the May 2020 futures contracts and had to dump them by Tuesday, 21 Apr 2020. This allegation cannot be proven because the fund mandate was to sell the contracts two weeks before expiry. So the plunge should be earlier.

Below is the table of USO holdings and they have rolled over to Jun contracts as of 20 Apr 2020. Regardless, we won’t know who is dumping the contracts causing the plunge below $0.

What does negative price means to you?

Typically, we need to make payment when we buy and receive payment when we sell.

This will reverse in a scenario of negative pricing – we receive payment when we buy and pay when we sell!

Yes. It is a bit counter-intuitive as this is the first time we have seen negative pricing in oil.

The principle to determine profit and loss still holds – buy low and sell high to make money. If you buy at -$6 and price goes up to -$4, you will be in profit. If you buy at -$6 and you sell at -$10, you will be in the loss.

How to buy oil

The best way to buy oil is to buy futures contracts on oil. But this might be too complex for most retail investors who do not understand futures. First, there are multiple expiration dates for the same asset and each contract is trading at a different price (below is a table of various contracts for Crude Oil).

Second, a standard contract is worth $20,000 (if oil price at $20) but you may only require to put up a margin of $5,000. Hence there’s leverage involved and your gains and losses will be amplified. Third, you trade these futures at commodities exchanges like such as Chicago Mercantile Exchange (CME) and you will need a futures broker to get access to them.

The best way to buy oil is also the most complex way to do so.

Oil ETFs are the easiest way to buy oil

The easiest way to invest in oil is through ETFs that is listed on the stock exchange. For example, USO is listed on the US stock exchange and you can buy it if you have a stock account that allows you to trade U.S. stocks. Do note that if you are based in Singapore, you need to pass the CAR (Customer Account Review) in order to trade this ETF as this is considered a listed Specified Investment Product.

Instead of invest directly through futures market, you can invest in this ETF and this ETF will buy futures contract on your behalf.

Contango Effect for Oil ETFs (Caution !!!)

On the surface, Oil ETFs seems like an easy and harmless way to buy oil. But a lot of investors do not understand that there is this contango effect.

Contango effect happens when prices for contracts expiring in later dates are trading at higher prices compared to the contracts expiring at earlier dates.

Contango is a deliberate result of oil storage. The storage creates room for buyers and sellers to better manage the fluctuation of oil prices. For example, when prices are low, buyers can buy oil and store it until prices increase in the future.

USO is not supposed to take oil delivery when the futures contract expire. The fund manager will have to roll over the contract by selling the expiring contracts and buy the next available month contracts.

If contango effect is present, the ETF will have to sell at low prices and buy at higher prices during this roll over process. This will add extra costs to the fund and the return for ETF will suffer. In summary, if you are trading USO ETF for short term, that should be ok. But if you are holding USO ETF for longer than a month, your return will be lower than oil price returns due to contango effect.

There’s a third way which is to use Contracts For Difference (CFD). But we realised the spread was huge. While the futures contract was trading at negative prices, we checked one of the CFD broker quoting around $12. That’s a huge price spread and not wise to to take such offer.

Conclusion

Personally, I will not invest as the oil price will be very volatile in the near term. If you want to speculate the short term price movement, the easiest way is to use an oil ETF but do not hold longer than a month as the contango effect will increase your cost of holding. The best way is to use futures contracts but the complexity would discourage many retail investors to participate. We don’t always have to trade everything. Doing nothing works too.