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Oil price crash and its implications- TREND CRYPT

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The price of oil is less than free today. But that does not mean that gas or gasoline stations will pay people to drive. This action has more to do with the complexities of the commodity futures market, which is what we will try to explain below.

What happened yesterday was a collapse of the oil price of more than 200% in its futures trade, which expired today. Futures trading is all about factors like storage limits and expiring contracts.

What is a future contract and why is it relevant to understand the collapse of the oil price?

Surely if you have time in the investment world you have heard of future contract markets in various fields. If not, we will explain briefly.

In the futures market, purchase and sale transactions are formalized through contracts, through which a commitment is acquired, under certain conditions. A future contract, in the stock market, is nothing more than a commitment to buy something on a certain date.

If you decide to buy or sell futures, on the day the contract expires, the future must be settled at the agreed price. Meanwhile, in the commodities market, such as oil, being tangible goods, the possibility of “physical delivery of the commodity” is contemplated.

Although the physical delivery of the commodity in futures is the exception and not the rule, it is something that happens. Investing in futures contracts necessarily means that the contract will expire when it is time for delivery of the commodity.

If delivery takes place, it takes the form of a negotiable instrument, such as a warehouse receipt, that demonstrates the ownership of the commodity holder at some designated location. This is the main problem with oil today: there is no where to store it due to oversupply and decreased demand. If you want to know more details about it, you can review it here.

How much is the global storage capacity of oil?

Global crude oil storage capacity is believed to be up to 6.7 billion barrels, including strategic and commercial storage. However, for technical reasons, only around 80% of this nameplate capacity is actually usable.

The current price structure, with rates for Brent and West Texas Intermediate (WTI) crude well below future delivery prices, creates strong incentives to store oil. Furthermore, with the massive imbalance between supply and demand, the tanks will fill up quickly, and it may not take long to test the limits of global storage capacity.

Assuming an average of 10 million barrels per day accumulate in the coming months, the effective reserve capacity could be filled in mid-July. According to the Center for Strategic and International Studies (CSIS), companies are looking for new places to store crude oil.

This includes converted wagons and pipes, but most are interim measures rather than solutions to a rapidly worsening situation. The collapse of oil seems almost logical in this context.

Why were only May futures contracts negative?

Easy, we are in a situation of “super contango”. Nobody wants physical oil anywhere, they just want it in the abstract. What happens is that as the date for an oil future expires, you usually sell it to someone else than if they receive that physical oil and you buy the future of the next month.

, Oil price crash and its implications- TREND CRYPT, Forex-News, Forex-News
Graph of oil futures for May 2020. Yesterday the oil crash was imminent due to the dynamics we have explained. Source: CME Group

The one who buys it is the one who stores that oil that you don’t want to have in your hands. You still have oil abstractly, while someone else keeps it. If oil prices are in contango, it means that June’s oil is above the May oil price.

So by rolling the futures (sell low on May and buy the highest on June) you are effectively paying someone else to store the oil for a month. The current situation is that People think that oil is valuable and want to bet, abstractly, on its future prices. However, at the same time no one wants any real oil right now because no one is using it and they have nowhere to put it.

, Oil price crash and its implications- TREND CRYPT, Forex-News, Forex-News
June 2020 oil futures chart. Today, those oil futures are at $ 11. Source: CME Group

The negative came because producers saw that most people bought the June futures, but no one wanted to buy the May futures. Everyone wanted oil but not now, due to lack of space, and so the producers found themselves needing to start paying for someone to take that physical oil.

conclusion

The price of oil did not crash to zero because no one needs oil, you can look into the future, or at futures prices, and see that there is, in fact, demand for oil.

Now, with the world economy closed, people need much less oil than they have. So oil became something that many people want, but not right now, so it is difficult to put a normal price on it.

No, you will not be paid to fill gasoline because of the oil crash. In reality, what happens is that nobody wants to receive oil because they have no place to store it, and they sought to acquire futures from other months, and that the oil they buy remains abstract.

Meanwhile, physical oil still needs to be stored, which is why producers pay for someone to take it. It is still more profitable than stopping production and reviving it when appropriate. We understand that a priori this is a bit complex to understand, but we hope we have clarified a little your outlook on this issue.



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