When the reality of the possible dire economic consequences of the COVID-19 pandemic began to set in, stock markets fell drastically in late March 2020. The overall markets recovered through April and early May, but uncertainty remains as the true long-term economic impact of the pandemic remains murky.
One market that has been particularly affected by the crisis is the crude oil market, especially the futures market that had prices in negative territory for the first time in history.
In this blog post, we discuss what happened in the oil futures markets in April 2020, and try to answer some questions that investors may have regarding oil-focused investments.
What are Oil Futures?
Oil futures are contracts that expire on a date specified in the contract. All oil specified in the contract must be delivered during the next month, in this case, May 2020. A key benchmark price for oil in the U.S. is the futures price for a type of oil known as West Texas Intermediate (WTI). On April 20, 2020, the U.S. benchmark price for WTI dropped below zero for the first time – and then fell to nearly minus $38 dollars a barrel for May futures contracts.
This price only reflected the futures price of WTI. At the same time, the actual price for WTI, often referred to as the “cash market” or “spot” price, was nearly $17 dollars per barrel and the futures price for another type of crude oil known as Brent Crude, a type of oil produced in Europe, was more than $19 per barrel.
People who follow the news and not the futures markets may have found this to be very confusing, since there was a lot of discussions that oil prices had gone below zero.
It was in fact the benchmark price for WTI that turned negative, not oil prices. The factors behind the negative price were unusual. Global demand for crude oil decreased substantially as products made using crude oil such as jet fuel and gasoline for cars weren’t being purchased nearly as much as they were before the crisis.
Why Oil Futures Fell to Historic Lows
Commodities, like crude oil, need to be processed, sold, and used in order to hold or increase in their value. If there is no end market, extracted oil needs to be stored, as it can’t be put back into the ground. Storing it in a backyard pool, for example, is not economically or environmentally feasible.
Because more crude oil was being produced than was being consumed, oil storage capacity, particularly oil storage capacity in the U.S., began to fill up causing the costs for oil storage to increase. In the U.S., there was fear that the cost to store the oil was greater than the value of the oil is stored.
In April, as the settlement date for futures contracts approached, those that held futures contracts that required them to take delivery of WTI had to make a decision; they had to find a way to store the oil that was going to be delivered to them (and incur the costs of storage) or they had to enter into offsetting contracts with people who were willing to take delivery and incur the cost of storage. The end result, for these specific futures contracts, was that market participants were willing to pay to have others take on their obligation to receive crude oil.
In May and June, the situation was different. We did not see a sharp reduction in prices before the settlement date for June delivery.
What Investors Should Know About Investing in Commodities Markets
Predicting a future price of commodities at any time is difficult in normal markets, requiring significant knowledge of the market for the commodity and expertise. When a unique, historic event like the COVID-19 pandemic comes along, it adds more complexity and economic uncertainty. This can lead to unusual supply and demand issues that can dramatically affect the price of commodities or the economic feasibility of entire industries – think travel.
Understanding Volatility in Oil Markets
Since the news of negative crude oil prices made headlines in April, the market price of crude oil has rebounded and producers have scaled back production, bringing WTI futures prices back above zero. The current price of oil – the one you see in the news and is reflected at gas station pumps – has risen as well.
However, the current unique and historic circumstances related to the COVID-19 pandemic continue to cause economic uncertainty, which is making it difficult to know what the demand for many commodities will be in the next three, six, or twelve months.
Investing in Oil Futures and Options
It’s difficult for retail investors to access the oil futures market directly. As mentioned above, oil producers and oil companies are the major players in this market. They have a business purpose to participate in the market.
Specialized investment funds, like ETFs, can give investors exposure to oil futures, and other futures, markets. Fund managers use the capital injected by investors to speculate on the price of oil. This could involve trading futures contracts and options on exchanges or enter into over-the-counter (OTC) derivatives in an effort to achieve a similar exposure.
As an investor, you should understand that you are not participating in the market directly. Without daily insight into the types of contracts or options that an investment fund holds, it is difficult to determine the true value of the fund or the impact that changes in commodity prices may have on the fund.
For example, you may see the current price of oil rising and recovering, and think you’re going make money. But the fund you hold may hold low- or negative-price futures contracts, which will have an impact on its value.
It’s also important to understand the structure, strategy, and holdings of an oil-focused ETF or mutual fund. An investor may think the fund they hold is tracking the price of oil when it’s really holding something else as a proxy for the price of oil such as a basket of oil company stocks. These types of funds don’t directly track the price of oil and can fall in price, even when the current price of oil is rising.
What Investors Can Do When Making Investment Decisions
As with any investment products, an investor should know what they are buying and have an idea of how it will perform. COVID-19 has disrupted the international economy in unprecedented ways. Every day brings news of economic hardship and shortages of goods and services. It’s important to stay informed and take an active role in your investments.
Talk to a Registered Investment Advisor
If you are interested in participating in commodities markets, you may want to seek independent advice from a registered investment advisor who specializes in this area.
An experienced advisor should have a good idea of the types of products available to you, and the risks that are involved. The advisor can help you understand how certain types of investments fit into your overall portfolio, and if there are other options available to you.
Manage Risk Appropriately
As we discussed earlier in the post, the futures market is complex, fast-moving, and risky at the best of times. When you add economic uncertainty created by a once-in-a-life item pandemic crisis, the risk for investors escalates as we saw with futures contracts dipping below zero.
Before entering into any risky investment situation, you should assess your risk tolerance and understand how much money you are willing to lose.
There is always the risk of investment loss, but the higher the risk, the more chance that you could lose some, or all, of your investment.
Volatility Creates Room for Investment Fraud
Where there is volatility, there are usually fraudsters attempting to take advantage of investors.
Fraudsters prey on investors’ uncertainty, anxiety, and desire to profit in a volatile market. In the past, regulators have seen fraudsters offering get-rich quick schemes when oil markets are booming.
In the case of a downturn, they use different tactics,. For example, fraudsters may start offering opportunities to profit from the volatility in the markets or oil alternative investments, like solar.
It’s important to stay fraud aware, especially when there is market volatility. Visit the fraud awareness section on BCSC InvestRight to learn more about common investment schemes and the fraud warning signs.
Report a Concern
If you have any concerns about a person or company offering an investment opportunity, please contact BCSC Inquiries at 604-899-6854 or 1-800-373-6393, or through e-mail at [email protected]. You can also file a complaint or submit a tip anonymously using BCSC’s online complaint form.
InvestRight.org is the British Columbia Securities Commission’s investor education website. Subscribe to receive email updates from BCSC InvestRight.