Futures Markets are a lot more interesting than you’d think. They are a key piece of financial infrastructure, that helped us build the modern world. If you’re interested, William Cronon’s book, “Nature’s Metropolis” is fascinating on the way that futures markets freed farmers and other economic actors from the tyranny of uncertainty and time. On Monday we got a rare, frightening look at what can happen when a futures market breaks. In this video we lay out why US oil prices fell into the -30s on Monday April 20th.
Despite what much of the business press has told you, this price fall wasn’t just a financial oddity. If certain things don’t happen, these prices risk becoming a monthly occurrence. As the Coronavirus depression proceeds, we are likely to see further examples of financial machinery breaking down. Get a preview by watching today’s video.
Video Transcript after the jump…
Hey there! So what the hell happened to oil markets on Monday, and what does it mean going forward? On Monday the May WTI futures contract, what is commonly understood to be the US oil price, went down to -36 dollars. In this Markets are Dumb series, we like to talk about what happens when reality intrudes on expectations. Well on Monday, reality intruded so hard that it broke the market, and pulled back the veil on how commodity prices function when nobody wants what you are selling.
The people who buy and sell the highest volumes of oil never see it. This is true of most commodities. Anybody who wants to speculate on the price of oil, or copper or coffee beans can buy something called a futures contract. This commits the buyer to purchase a certain amount of a commodity, on a certain date. For our purposes the important date was Tuesday April 21st, the day that the May WTI futures contracts came due. Futures markets are a good deal for the driller, or the miner, or the farmer because it allows them to hedge against a fall in the market and make financial plans, and it’s good for everyone, from investors to policy makers to have the information that the futures markets provide.
Normally it looks like a futures contract has the same amount of risk of a stock or a bond. The price can rise or fall, but usually there will be somebody who wants to physically take delivery of that oil. This allows the oil trader to easily sell their investments in one month’s futures and buy the next month’s futures, and keep on merrily speculating.
What happened on monday was that for the first time in a while, maybe ever, the oil traders were forcibly reminded of the CONTRACT part of the Futures Contract. People who held these securities couldn’t get rid of them. Because of Coronavirus demand destruction, all the refiners or tankers or whatever who would normally take physical delivery of this oil already have more than they need. A bunch of people with no infrastructure beyond their laptops were faced with the requirement to physically pick up a bunch of oil.
And that’s why WTI oil prices fell into the -30s on Monday. Oil traders were willing to pay people to get rid of that responsibility. On Tuesday, the WTI prices we all follow shifted to the June contracts which are trading in the now saner looking teens. But this is still incredibly low, and if a whole bunch of US companies don’t stop producing, or don’t build a ton of storage, we may find ourselves in a similar situation on May 19th when the June futures contracts expire.
What’s interesting is how much of a US problem this is. WTI went negative, but Brent, and other international prices did not. Russia and Saudi Arabia have very serious long term problems due to these low oil prices, but they are much better positioned in the short term. Their more consolidated industries are capable of cutting production for a couple months and surviving. The many smaller companies in the United States cannot. If they stop pumping, they go out of business, which most of them should have done years ago anyway. Over the next month or so, a bunch of rich people, probably including the president, are going to tell you that we should be more like Russia and Saudi Arabia, and start using a cartel to control our output, and save all the US’s bad oil investments. Ignore them, this would be the next step towards turning the United States into a petro-state, and a petro-state is not a good thing to be.
As far as what this means in the long term, I’ve already laid out my expectations a couple times, and I don’t want to bore you by being repetitive. Oil prices will remain in the toilet for as long as it takes for the US oil industry to consolidate and shrink significantly. Then maybe a year from now, maybe five years from now, oil prices will spike briefly, creating an electric car explosion, and the end of the petro-state model. This Coronavirus crisis is an acceleration of things that were already going to happen.
Thanks for watching, please subscribe, and if you want my detailed oil predictions, check out “how the oil market dies” from fall 2018, and the recent update video “Saudi Arabia goes to war”. Thanks.