Back to Drew's Views
May 19, 2020
Previous
Next

On Negative Oil and Futures Prices

Markets

“Whoever controls oil controls much more than oil” said John McCain in 2008. And he was right. That statement is almost always right. Except for a brief and now famous period in April of last year.

But first, a quick primer on spot oil prices and oil futures, and the difference between the two:

When we see oil prices in the headlines, they are usually referring to the price of a nearby futures contract for either West Texas Intermediate (WTI) or Brent crude. Both of these are “light, sweet” crudes (WTI has slightly less sulfur, so is slightly sweeter, and lower API gravity, so is slightly lighter) and these two have evolved as a proxy for the hundreds of other grades and types of crudes produced around the world; even heavier, more sour grades.  

Like Darwin’s finches, as our tectonic plates drifted to and fro over many millennia, each of our crudes developed slightly different consistencies, and they have different names too. Some of us in the U.S. may have also heard of “Alaska North Slope” or “Light Louisiana Sweet” or even “Mars Sour”. In Mexico, there is “Isthmus”, in Venezuela there is “Tia Juana Light”, and nearby in Ecuador, there is “Oriente”. In West Africa, there is “Nigerian Bonny Light”; while 500 miles to the north in Algeria there is “Saharan Blend”, and 2,000 miles to the east there is “Iran Heavy”.

OPEC’s reference prices, for example, are a mix of a few of these above (and many others), but broadly, people in the world will quote WTI or Brent when they discuss where oil prices are.

But that’s pretty simple stuff. The less simple stuff is that there are spot barrels, forward barrels, and futures contracts; and they can be very, very different.   

The spot barrel is the oil you can buy right now in the cash market for (almost) immediate delivery. Forward barrels are similar cash market transactions where you contract today for delivery of oil at some point in the future. The futures market is simply a marketplace reflecting (in some cases influencing) where these forward prices are being transacted. These futures markets for Brent and WTI are so liquid (oil trades like water…) and well-established that producers and consumers (and speculators) will refer to one or the other when they are pricing other crudes. LLS (the Light Louisiana Sweet crude mentioned above) may trade at a discount or premium to WTI, but more often is contracted in a relationship to Brent (because Brent is imported into the US Gulf Coast).  

So these futures prices bounce around, reflecting expected forward supply and demand for WTI and Brent. Meanwhile, the price of other crudes will also bounce around, not only reflecting global supply and demand for WTI and Brent, but idiosyncratic features to that particular crude (e.g. its location, relative sulfur content, density/API gravity, proximity to shipping channels, pipelines, refineries, etc.).  

With the futures market specifically, there is the “first nearby” delivery month, the “second nearby” and so on. It is somewhat active 12, or even 24 months out, but the real action is in the nearby months. There are futures contracts expiring each month that are approximating where cash transactions will take place in the month of delivery. If it is early January, there will be a contract expiring in late January for delivery in February. This is the Feb contract. There is a March contract that also trades, an April contract, and so on.

And this is where it gets fuzzy for people.

You can’t blame them, but many observers (or even participants) think that the oil futures market is indicating where Mr. Market expects oil prices to be in the future.

That isn’t what it does.

Futures prices simply indicate what demand is today for delivery of crude in various periods down the road. This gives rise to the month-to-month spread in oil futures prices.  The February, March, and April futures prices noted above are usually different.

Moreover, calendar oil spreads (e.g. the Feb-to-March or the March-to-April) are typically counterintuitive. When crude prices are in the normal “backwardation”, out month futures prices are lower than the nearby month. This is because people want oil now. They don’t want to wait a month, but they would rather wait a month than two months, and they would rather wait two months than three. In other words, when futures prices for the out months are lower than they are today, it doesn’t mean that oil traders expect spot oil prices to fall. In fact, it often means the opposite.  

Similarly, if oil markets are in severe contango (a forward month “carry”, where futures prices are higher than spot prices), this does not mean that the market expects oil prices to necessarily rise in the future. It rather is simply reflecting a depressed appetite to own the spot barrel.  

We saw this go to a previously unimagined extreme last year when pipeline and storage capacity was exhausted, refineries were shut down, and there was literally no marginal demand for the nearby barrel. A steep contango is often indicative of a very weak demand (or strong supply) environment.

There sure was.

On April 20, 2020, there was so little appetite for immediate delivery of crude oil those owning May futures couldn’t find any buyers anywhere close to the previous night’s close of $18.27. Some of the holders of that nearby contract which was expiring that next day (April 21) didn’t want - or didn’t have the capability - to take delivery of WTI in Cushing, Oklahoma, so they needed to sell. But they couldn’t offload their barrels at fire sale prices of $15, or even $10, or even $5/bbl.  

In fact, they couldn’t even give it away for free. They couldn’t sell their oil at zero.

For a brief moment that Monday afternoon, people that owned the May 2020 futures contract had to pay nearly $40 for someone to take it off their severely bloodied hands.[1] And they did.

There were many articles describing these events, and they were written by folks that know a lot more about oil and oil markets than we do. But there are two key takeaways that we all should use as our base case for how to think about oil going forward.

1) It is difficult, if not impossible, to consistently predict the direction of oil prices, nor the magnitude of their moves, and

2) When oil futures are in contango, it is usually (and counterintuitively) associated with periods of current weak demand; and when they are backward, it is a reflection of current strong demand.


Subscribe and sign up with your email address to receive the latest news and updates
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

FOOTNOTES

[1] Image Credit: There Will Be Blood (2007), Paramount Vantage, Miramax, Ghoulardi Film Company

Download PDF

Topics

Markets

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for informational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such.The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

YOU MIGHT ALSO LIKE

Text Link

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.

Text Link
Text Link

OK, 2022 Was a Disaster for Tesla - What Next?

There still could be significant downside, but it's going to take fundamental misses to get there; and $TSLAQ has to admit that the screaming short at $400 has fallen 70%.

Markets
Behavioural Finance
Read More
Text Link

Stock Market History, Illuminated, 2022 Style

I’ve been keeping a graphic of the long-term performance of the US stock market for many years now, and I’ve been sharing this information in the histogram below. I think it does a reasonable job of revealing how long-term returns are manufactured and the tilts over time. I’ve color-chunked the data by decade to highlight decades of historical weakness as well as periods of strength. I’ve also added additional tables and charts which I think are interesting, and in some cases, stunning.

Asset Pricing
Factors
Markets
Valuation
Read More
Text Link

What Stands in the Way Becomes the Way

I don’t think that Aurelius, Frost or Zweig would disagree that the road less traveled might have a little more alpha in it.

Markets
Behavioural Finance
Stock Picking
Read More
Text Link

For Investors, a "Never-Sell" Mantra is a Song for Fools

On the misleading claims of Hendrik Bessembinder about diversification; and the convenient, post-hoc, and the spurious conclusion to always buy and hold.

Asset Pricing
Markets
Portfolio Management
Stock Picking
Read More
Text Link

A Conversation between Drew Dickson and Morgan Housel

A discussion between Drew Dickson of Albert Bridge Capital, Morgan Housel of The Collaborative Fund; moderated by Jamie Catherwood of O'Shaughnessy Asset Management

Asset Pricing
Behavioural Finance
Markets
Read More
Text Link

Conversation with Dr. Daniel Crosby on his Standard Deviations Podcast

Drew joins Dr. Daniel Crosby on the Standard Deviations podcast.

Asset Pricing
Behavioural Finance
Markets
Sports
Read More
Navigations
HomeTeamDrew's viewsPressContact
Disclaimers
Legal & regulatoryPrivacy policyCookies policy
How to get in Touch
info@albertbridgecapital.com

Subscribe to Drew's Views

No spam. Unsubscribe anytime.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
© Albert Bridge Capital 2022
Website by SW10media.com
homeTeamdrew's viewspressCOntactDisclaimers