Oil Price War: Crude Oil Goes Negative

Hello and welcome back to Breaking the Dollar. This week's show, if you knew from our teaser for last episode last week, was already planning to address the oil price war that has been brewing for more than a month between the US, Saudi Arabia, and Russia. But the news is moving so fast these days that April 20th, 2020 happened. It will definitely be a week that goes down in the history books because it is the first time that the paper price of oil on the futures markets went negative for almost two days. Obviously that raises the question, what does that even mean? How is that going to impact other markets? So I will address all that that threw a new wrinkle into the mix here, but I might as well start where we were going to begin anyway, and that is with the existing tensions in the oil market.

So for much of the last year, crude oil has traded around $60 per barrel. Now just to get this out of the way to avoid any confusion, the two main oil prices everyone references are WTI, that's West Texas Intermediate, which is what it sounds like it comes from West Texas. And the other big oil price is Brent crude, and that is basically the benchmark for Europe. But oil comes in a lot of different forms, a lot of different grades, from Canada, from Venezuela, the Middle East. All of these kinds of oil have slightly different prices, there's transportation costs, but in most cases they end up being mixed in with these more refined flavors of oil they're sometimes called. So when I'm talking about the oil price, I will be referencing WTI, basically the US standard. You can think of it almost as the petrodollar price, and throughout 2019 that was pretty stable, like I said around $60 per barrel.

For perspective, that's about half of its all time high, so it is well off of its highs from years ago. But it is also about double the most recent lows for oil in early 2016 when it was as low as $30 a barrel. So in some ways $60 per barrel oil is kind of this middle ground, it was right in between its widest trading range. And then of course in January and February, the early signs of coronavirus happened, and we had the subsequent shutdown or lockdown of much of the world's economy. As a result, the price of oil basically collapsed. It went down from $60 to below $50 to as low as $20 per barrel. And it's really not hard to see why that happened. Air flight traffic was as low as it was in the 1950s with nobody going to work. There were very few commuters on the road driving cars, factories are shut down. So there's just much less demand for oil when the economy has stopped like this.

Because oil is such an important input to so many industries, the collapse in prices so quickly has a cascading effect across many different markets. So that brings us to the oil deal that was brokered with Russia and Saudi Arabia recently. Now it is not all that unusual for the US president or the United States to negotiate these kind of agreements with the OPEC oil cartel. And that is mainly Saudi Arabia, several other oil producing countries. And then now it's kind of considered OPEC plus because they include Russia and they have invited Mexico, but they're still not really part of the group officially. But nonetheless, this has happened in the past where the US tries to broker a deal on oil prices. The difference is that usually the United States negotiating position is for lower prices because we want to see cheaper gas at the pump.

However, over the last decade, the US is now a major oil producer. We're one of the major energy exporters around the world. So that changes the calculus a little bit. Now the United States has an interest in oil prices not getting too low. That's what this deal was supposed to solve. Both Russia and Saudi Arabia reiterated their support for the deal and it did seem to lift the oil price slightly. We got back into the $30 per barrel range. The main reason that the deal lifted prices is because Saudi Arabia and Russia agreed to cut their oil output. And this is the standard playbook from OPEC is that they announced they will cut production in order to reduce the supply and increase the price. But ultimately, not every country in OPEC completely abides by the production cuts. And you can sort of see why it is a tense negotiation.

Now another aspect in the politics of all this and why you can consider it an oil price war is that in becoming a major energy producer, the United States now has a large shale oil industry. If you're unfamiliar shale oil comes from the process of fracking and as an industry, shale has grown considerably at the expense of more offshore drilling. Aside from the obvious environmental resistance to shale drilling, one of the problems is that the shale industry needs the price of oil to be rather high to remain profitable. I think it was in the $50 to $60 range. So as I mentioned before with all these different grades of oil and all of the different flavors, the prices vary and the price at which these industries are profitable also therefore varies. So the agreement was reached. But of course, these are never entirely binding. And as I said, there's always this political battle that goes on about how strictly the output cuts are enforced.

Now to mention that the price of oil is obviously very important to the rest of the world economy. As I said, it is the essential input to basically all types of industries, manufacturing, medicine, travel, you name it. And then very quietly, the next bit of news that I picked up on last week was that the CME, which oversees commodities trading on Wall Street, announced that it had updated its software in order to accept negative values for the price of oil. And this did raise a few eyebrows. It was rather quiet. There wasn't much uproar about it to the point that I did see some oil traders on social media as recently as yesterday saying this was the first they had heard about it. But obviously with that move to update the software, to some extent, somebody saw this coming, right? And the reason that they could have seen it coming was because we were approaching the monthly expiration for the May futures contract for crude oil. And again, I'm referencing the WTI. Expiration is always a volatile trading time. It's when market participants are either going to close out their position, and in the case of oil, presumably take delivery. That means physically get the thousand barrels of oil that are in the contract. Or they simply roll over their position to the next month. So that would mean you sell your May contract and you buy the June futures contract.

What made this expiration in particular such a big deal is because, due to the lack of demand for oil during the coronavirus, there is now a huge supply glut that there is more oil than anybody needs. And they are literally running out of places to store it. So because of that supply glut, nobody in the markets is intending on taking delivery of this month's contract for oil. If you did so, it would also be very expensive if you could find storage because there is running out of room. With all of that in mind, and keeping in mind that as I said, some of the people involved in this market and in the trading weren't even aware of the negative value news released by the CME a couple of weeks before. So as a result, this oil contract became illiquid. And everyone who did sell it had a massive effect on the price.

What we saw is that some players in the markets were late to the party. Many traders had already rolled over to the next month so anyone caught holding the bag of the May contract that nobody wants was essentially holding something that was rapidly losing value. And this is where the situation got surreal. So the day before I'm recording this, the price of oil started going down pretty significantly. It got down below $10, below $8 a barrel. And for reference, the lowest closing price for WTI oil in the modern era was still above $10 per barrel back in 1986. So in the middle of the day, we're seeing these all-time lows for oil, but it didn't stop. It got down below $6, below $5, below $4. And obviously, this started garnering attention and people are asking what's going on. It really was strange to watch it happen in real time. So by the end of the trading session, crude oil prices have lost over 300%.

So mind you, I didn't actually think it was possible to lose more than 100%, but that definitely happened. And it ended the day at negative $37 a barrel. So in literal terms, what that meant is that you're willing to pay someone to take the oil off your hands rather than them paying you. It is somewhat reminiscent of the negative interest rates, as we've talked about on the show before. But the explanation for why this could happen has everything to do with the supply glut right now and the fact that this contract was expiring and no one wants to take delivery. The negative price does mean that there is this cost for storage. So unfortunately, it doesn't translate into oil being free or you being able to go to the gas station and get paid to fill up your tank. I mean, unless you're able to buy a thousand barrels of oil at once and have a place to put it, you really can't make any money on this deal. And granted, this is undoubtedly a short term disruption and some chaotic panicked trading in the markets. It has less to do with an actual long term shift away from oil being a valuable commodity.

But nonetheless, it obviously has some domino effects. There are plenty of industries that rely on extracting oil or energy from the ground and then selling it. On the financial side on Wall Street, there are obviously many derivatives that are tied to the price of oil. And so all of those securities blew up. I really can't even conceive how anybody's investment vehicle or model for an investment could take into account the chance that the oil price would be negative and lose 300% in one day. For that reason, I don't believe that this episode is actually going to do anything to change the status or role of the dollar and the petrodollar and their importance in the global economy. But what we could see is negative oil prices again in June. For as long as the economy stays shut down and there is a supply glut in oil, this type of situation could happen again. And it is almost fitting in a year of firsts and unprecedented things happening in the financial markets that this is just one more strange thing to add to the list. That does it for this week's episode. I really appreciate everybody tuning in. Thank you so much for listening. Hope you enjoyed it.

We will move on to our question from the listeners. This week's question comes from Vance. It doesn't say where. And he asked is his gold going to an all time high this year? That's always the million dollar question, of course. It's certainly in the realm of possibility. The fact that the gold price broke above $1,750 this year for the first time since about 2013 is definitely a sign that we could continue to head higher. We should remain cautious and kind of conservative with our outlook though because of the unpredictable, uncertain nature of everything that's going to be going on for the rest of the summer. That doesn't mean gold cannot continue to climb later in the year. I just think that 2021 is probably a better target because we'll have a lot more clarity on how the global economy is recovering. Whereas right now while we're still in the midst of it, I think volatility is going to continue to plague all assets and that includes the precious metals. Thanks again for checking out the show with, again, how fast everything is moving lately. I think that next week's episode is TBD. It's going to be a mystery box. So be sure to tune in and find out