The May contracts for West Texas Intermediate - WTI tumbled as low as -$40 a barrel on Monday, April 19 which means producers or traders are paying buyers to take oil off their hands. The June contract for WTI is down to $11.57 a barrel, at the time of this article.

 

What has caused such a crash in oil price? Firsts let’s get a few technicalities out of the way.

 

Understanding the benchmarks:

There are two main oil benchmarks for tracking oil prices: West Texas Intermediate (WTI) for North America and Brent Crude for international.

 

WTI’s main storage facility is in Cushing Oklahoma, also known as the pipeline crossroads of the world, which is now near its storage capacity.

 

Brent Crude however stores in oil tankers, dabbed as “very large crude carrier (VLCC)” or “ultra large crude carrier (ULCC)” which provide more flexibility.

 

How do trading commodities work?

 

Unfortunately, spot crude oil is not investable. One must trade in crude oil futures.

 

In trading futures, when contracts expire, investors must take “physical delivery” or close the contract prior to delivery. In this case, given the scarcity of storage space, contract holders without storage capacity are at the mercy of potential buyers.

 

And what has caused the inventory build up?  Simply put, as a result of the pandemic, oil demand has been reduced by roughly 1/3, and while OPEC has reached an agreement to reduce supply, this will not take effect until May.

 

What is the long term outlook for oil?

 

Demand for oil was weakened prior to the covid-19 outbreak and now the demand side of the equation has worsened while there is still plenty of supply of oil. In 2019, US has become an oil net exporter for the first time in decades. This sharp reversal spells significant impact on the oil market.

 

Is the current environment a buying opportunity?

 

Given the low price of oil, it has attracted renewed interests from investors. There are ways to gain oil exposure; one is to invest in energy companies while another is to gain exposure through futures contracts or exchange traded funds.

 

In the current environment, it is unclear when the oil price recovery will take place given the demand and supply imbalance. Many of the oil producers are now under pressure to reduce or halt their dividends to preserve capital. 

 

As for ETFs, in stressed market environments they can trade at a high premium or at a discount to the underlying investment holdings. United States Oil Fund (USO) for example is an ETF that seeks to replicate the daily price movement of WTI and its recent collapse provides a cautionary tale of the complexity to speculating in oil prices without fully understanding the mechanism of how the ETF is constructed.