First negative interest rates, and now negative oil prices. Is the world coming to an end?

The price of the May crude-oil futures contract closed yesterday at negative $37.63 a barrel. The buyer of that contract is entitled to receive 1000 barrels of oil in Cushing, Oklahoma in May and in addition the buyer is entitled to receive $37,630. Sound like a pretty good deal?

A month ago there were around a half million such contracts outstanding, promising delivery of half a billion barrels of oil to Cushing in May. That’s far more than could ever be physically delivered, and it’s perfectly normal. In the vast majority of those contracts, the buyer had no intention of receiving oil and the seller had no intention of delivering oil. The plan of the buyer was to sell the contract to somebody else before time for delivery, and enjoy the gain if they sell for more than they bought. The seller likewise planned later to buy a contract; in effect, their original offer was a short sale, which they later cover by buying. You can think of the second contract that closes each individual’s initial position as between the same two parties as the original contract so that the two trades exactly cancel. For most of the original contracts, no oil actually changes hands in May.

The anchor for the system is the fact that the buyer has the right to receive physical delivery if they choose to hold the contract to expiry, and could plan to put the oil into storage or ship it immediately into another pipeline. If I can store the oil in Cushing for a cost of a few dollars a barrel, that’s a valid option. But the higher the cost of storage, the bigger problem I’ll have on my hands if I actually take physical delivery.

The May contract expires today, so if you haven’t sold your position now, you better plan on receiving your 1000 barrels of oil. But you can still buy oil for delivery in June, or for delivery in July, or other future months. Here were the prices of the different contracts at close yesterday.

(Click on image to enlarge)

There is a basic arbitrage that connects the futures prices in any consecutive months. By buying the July contract you could lock in an option to receive delivery in July at a cost of $26.28 per barrel. You could plan on storing the oil that month and selling in August at a guaranteed price of $28.51. If you expect the cost of storing oil in July to be $2.23 per barrel (28.51 – 26.28 = 2.23), you’ll just break even by buying the July contract and selling the August contract. If you think the price you’d have to pay to store the oil in July would be less than $2.23, you should buy July oil and sell August oil. Arbitrageurs following that trade will drive the July price up and August price down. In equilibrium, we’d expect the price differential between months to represent the cost of storage. Applying that interpretation to the above numbers, the cost of storing a barrel right now is imputed to be around $60 a barrel (nobody would do the deal with you yesterday at any reasonable price). The imputed storage cost is about $6 in June. There’s a horrific storage bottleneck in Cushing right now, but traders are betting that it’s going to be more manageable by summer.

An added factor in calculations like this is that some businesses like refiners always need to keep some oil in storage. Those parties have an incentive to store oil even if they do so at a loss. This factor is called a convenience yield. The more general arbitrage relation is that the difference between the August price and the July price is the storage cost minus the convenience yield. The calculations in the paragraph above were assuming a zero convenience yield. When inventories are as abundant as they are right now, that’s probably a reasonable assumption to be using.

So that’s the explanation of the negative prices. The bigger picture is that the flow of oil headed for delivery to Cushing in May was bigger than the consumption in May, and there was no easy way to store the surplus. That caught buyers of the May futures contract in a squeeze, unable to close their positions at the terms they expected. The situation will be helped some as upstream producers shut down. But the bigger problem is that demand for oil has collapsed. People aren’t flying in planes and they’re not driving to work.

The low price of gasoline will mean some added spending power for those folks who are still driving. But don’t count on any economic stimulus from that. Most American oil producers can’t make a profit at $30/barrel and are hemorrhaging cash at even the June price. The collapse in spending and employment by U.S. oil producers will be a big drag on the economy. The pending bankruptcies are another worry for stability of the financial system.

So no, negative oil prices are not the end of the world. But no way do I see them as good news.