Common perception: Supply is too high, and demand is too low.
Reality: Mechanics related to the contracts that govern the purchase of oil exacerbated the impact of the price decline.
While the common perception is true, the reality is more nuanced. Today we look at that nuance.
On Monday, April 20, 2020 contracts for West Texas Intermediate(WTI) oil to be delivered in May fell from US$17.85 per barrel to a low of minus US$37.63 — that is, the sellers were paying the buyers to take their May oil contracts off their hands.
To understand how this happened, you have to understand what happens when an investor “buys oil”. When investors “buy oil” they are investing in one of two instruments.
A contract: They are entering into an agreement to pay for and physically receive a specific amount of oil in the future. The agreement sets a price and a date (the “expiration date”) at which the oil will be delivered in exchange for cash. Since most investors do not have the space to physically store oil, they usually sell these contracts as the expiry date approaches to entities which can receive and use the physical oil such as refineries, pipeline companies, airlines, etc. In other words, it is rare for an investor to hold a contract to buy oil, all the way to the end of the contract. Traders at large hedge funds, asset managers or banks often buy these contracts as a tool to bet on oil price movements. They usually sell them prior to expiry so they can avoid taking the physical oil.
An exchange traded fund (ETF): Investors can also purchase shares in an ETF that mimics the movement of oil. An ETF trades just like a stock on the stock exchange. Exchange traded funds buy these oil contracts in very large quantities. It is worth noting that the world’s largest oil ETF (USO) had received billions of US dollars in fresh funds in recent weeks. This ETF owned roughly 20 per cent of all outstanding West Texas Intermediate contracts with delivery in May. Like retail investors, ETF’s cannot take delivery of the physical oil. They too sell the contracts near to expiry and simultaneously purchase another contract with an expiry date further into the future. Picture this: The world’s largest ETFs selling 20 per cent of all WTI contracts for delivery in May. This helped to contribute to a decline in the price of the contract. However, according to a Bloomberg article, ETF’s sold their positions before the contract prices went negative.
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