Why Oil Prices Really Crashed Monday (and What to Trade as a Result)

Keith Fitz-Gerald Apr 22, 2020
16 

Oil prices dropped off a cliff Monday as a key futures contract went “negative” for the first time in recorded market history. Then, the selling continued Tuesday.

Oil will probably have rebounded by the time you read this which is great for savvy investors.

Today we’re going to talk about what really happened, what that means for you money, and, of course, how to trade that information based on what happens next.

Hopefully, for some terrific profits!

Here’s the skinny

First, what are “negative” oil prices?

Oil is traded using a series of futures contracts that correspond to specific monthly deliverables. Prices typically vary by month as a function of anticipated demand, spot prices, and the remaining time until delivery.

As I prepared this column for example, the May 2020 Globex CME contract is trading at $5.38, while the June 2020 contract is $13.63, and the July 2020 contract is $22.12.

Figure 1 CMEgroup.com

This makes oil very different from stocks where there is no underlying commodity and no delivery obligation, and prices are quoted based on a limited number of shares at any given moment in time.

Oil prices normally converge as buyers – think airlines, refineries, transports here – get closer to actually taking delivery of the oil they’ll need. That’s why most oil prices are most typically quoted using the nearest term contract.

Monday, however, a very different situation emerged.

Prices on the May contract tanked – sorry, couldn’t resist the pun – because “nobody” wanted more oil in May and storage facilities were full. The situation got so bad before the end of trading that prices actually settled at negative $37.63 per barrel.

Normally prices are positive because that’s what buyers have to fork over per barrel to take delivery but in this instance, they became negative, effectively suggesting that producers would have to pay buyers to take their oil.

To put this in context, imagine taking your favorite car out for a drive.

Normally, you’d pay to fill up because you need the gasoline and the station has effectively “stored” it for you until you needed it. Had you gone driving Monday afternoon, the station owner would have paid you to take the fuel!

This is a “180” that has never happened before with oil futures contracts.

Second, why did prices drop so fast?

This is where things get interesting and, frankly, problematic.

The exchange traded funds that everybody thinks are so neat are, in fact, huge problems in situations like this one, especially when commodities are involved.

Take United States Oil Fund LP (NYSEARCA:USO), for instance.

The financial alchemists who created USO never intended to take delivery of the West Texas Intermediate Light Sweet Crude oil prices it tracked. By design, that responsibility falls to the USO’s administrator and general partner – the Bank of New York Mellon and U.S. Commodity Funds, LLC respectively.

This created a double-whammy:

  • Neither the bank nor the fund operator were any more prepared to take delivery than you and I; and,
  • Storage facilities in and around Cushing, OK – the primary delivery and price settlement point for WTI crude – were full so there’s no place to put more oil.

Normally demand would make this impossible, but the coronavirus has effectively eliminated that which, in turn, forced prices down at every step in the demand curve.

This makes sense when you think about it.

Six months ago, demand was constant pre-coronavirus, and you could see that clearly in the oil futures curve (which reflects prices by month over time). Then, demand vanished as social distancing came into effect.

People aren’t driving as much, if at all and the drop in related fuel consumption is so graphic that many auto insurers are giving rebates or handing back premium to compensate consumers who have parked their vehicles. There is so little gasoline needed, that there are now reportedly 13 states where the average cost of a gallon of gas is less than $1 if memory serves.

At the same time, air travel bookings are down 103% year-over-year with the average domestic flight now carrying just 10 people per hop. International flights reportedly average just 24 people per flight and that’s, mind you, with something on the order of 90% of capacity already removed from the system.

Trains, factories, trucking fleets… you name it … demand simply fell off a cliff.

The June crude contract is now under pressure as traders come to terms with the fact that May may be just the tip of the proverbial iceberg. Again, as I prepare this article ahead of publication.

Many people are banking on a recovery, but I think the demand fallout will persist through much of the summer. In fact, I think that oil demand may be another 45 million barrels per day lower than it would under normal circumstances versus “just” the 39 million barrels I’m hearing bandied about in the press.

As a result, I think there’s a good chance the June contract may go “negative” too because the trajectory is similar if the company doesn’t jumpstart demand and reopen soon.

Which brings me to the fun stuff… how you trade a situation like this one.

Normally, I’d suggest USO itself because I think oil will come roaring back when demand resumes. It’s dropped 79.48% since January 6, 2020, and is trading at just $2.70 as a write.

However, I’m suspect about USO itself. Many investors think it’s a proxy for oil but that’s not true. In fact, USO is another in a long line of commonly misunderstood trading products that has no place in an average retail investor’s portfolio.

I think there’s a good chance USO will be repriced or even liquidated if the prices for crude don’t come back in line relatively quickly. Some of that is going to be simply a repricing as more futures contracts “roll” – which is a technical story for another time.

The situation reminds me another fancy-pants ETN that blew up in early 2018, XIV.

Like USO which is intended to track a derivatives pricing model based on oil, XIV was supposed to capitalize on the gradual erosion of volatility that existed at the time. However, XIV imploded and became worthless almost overnight on Monday, February 5th, 2018 when the Dow Jones got pummeled and volatility exploded.

Anybody banking on a decline in volatility got scorched.

I recall vividly talking to several traders that evening as XIV dropped 90% in after-hours trading. Like oil traders this week, they lost billions. XIV, incidentally, did not reprice like I expect USO to and ceased trading February 20th.

Speaking of which, I think USO could have lottery ticket potential if the Bank of New York Mellon doesn’t pull the ETF. My suggestion would be to purchase long-dated call options like the 15 January 21 $6 Calls, instead. They’re trading at $0.36 to $0.37 cents as I type but are likely to drop further while USO gets its act together which means you could get even a better bargain with more upside potential.

Or, if that’s a bit to “hot” to handle or you don’t have the trading chops, consider buying a major oil player like Schlumberger Ltd. (NYSE:SLB).

I’m drawn to the fact that the company as significant number of long-term contracts that can carry it through the next 12 to 24 months without undue price exposure.

What’s more, Schlumberger recently announced a dividend cut so it’s beaten down at just $14.69 a share, roughly half of where it was trading at we entered 2020. LEAPS calls would be a great alternative here, too.

In closing, these are both highly speculative trade suggestions so treat them accordingly.

Until next time,


Keith

16 Responses to Why Oil Prices Really Crashed Monday (and What to Trade as a Result)

  1. Marcus Presar says:

    What happens to those January USO calls if USO is dissolved?

    • Seth says:

      Great article,very knowledgeable and great way of explaining the subject.

    • Keith says:

      Howdy Marcus and that’s a great question.

      Usually there’s an orderly procedure to wind everything up but that’s not clear at the moment. Normally all trading will cease and any options not in the money will immediately become worthless. Those in the money will have no time value. Holders should be able to choose to receive cash or wait for expiration exercise.

      I’ll keep you posted as I learn more.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  2. R Joe Dunnam says:

    I ALWAYS ENJOY HOW YOU TAKE AN INVOLVED CONUNDRUM AND WHITTLE IT DOWN TO JUST A FEW LOGICAL CHOICES FOR THOSE OF US ON THE PERIPHERY OF STOCK TRADING. GREAT INSIGHT! I PERSONALLY WAS INVOLVED IN XIV TRADING BUT WAS LUCKY ENOUGH TO CASH OUT WITH SOME WINNINGS. WIN SOME, LOSE SOME

    • Keith says:

      Thank you so much for the kind words! You made my day, Joe.

      Good job on XIV, by the way!

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  3. S. [S. 4 stanley] POLCHINSKI says:

    This is 4 a retiree – single w- out finds?
    No face book – i get no thing ?

  4. Jerry Lee Travers says:

    If you were going to buy an SLB leap now, which one would you look at now?

    • Keith says:

      Hi Jerry.

      I’d be looking ATM about a year out so there’s plenty of time for the markets to recover, assuming that stays in the proverbial cards.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  5. jeff says:

    do you know if the price of uso could go negative and have a margin call to retail investors if the front month contract does. Thx Jeff

    • Keith says:

      Hi Jeff.

      Technically, it’d be the front month of the futures contracts tracked by USO that would go negative so the margin call to futures investors would be immediate as a function of the contract. It’s unclear what the impact on USO will be, though. That is being repriced as I type, presumably to avoid it zero-ing out.

      That said, normal brokerage margin requirements would apply to USO itself.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  6. matt Mattison says:

    Good review . Keep us appraised every day

    • Keith says:

      Thank you, Matt.

      I will do my best!

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  7. Mark says:

    Hello Keith,

    I just read that USO is going to do an 8 to 1 reverse split effective Monday. What (if any) impact does this have on your recommendation for the Jan 21 Calls?

    Regards,
    Mark

  8. said elkhamrichi says:

    bonjour….merci….

  9. a gold says:

    if oil going down 100 below where can i make money tank you

  10. Keith says:

    Hello Stanley.

    I’m not quite sure what you’re asking; can you re-frame the question?

    Best regards and thanks for being part of the Total Wealth Family, Keith

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