Like me, you may have seen this article in the NZ Herald Tuesday, in which business reporter Jamie Gray discusses why negative oil prices likely won't drastically affect NZ's gas prices. Long story short, most of the price of gas is tax and oil prices were only negative in the States.

But how do oil prices go below zero? Why would somebody pay you to take barrels off their hands? Can you grab a few?

Hearing prices are negative sounds like oil is worthless, but this is far from the case. To understand what exactly is going on, we must look at the quirks of the oil industry and commodity exchanges.

How to Buy and Sell Oil

You can't swing by your local Placemakers and pick up a barrel of crude. So where can you buy some?

Exchanges exist to buy and sell commodities in the same way stock exchanges exist for buying and selling company shares. However, you wouldn't usually pay for the oil and start delivery straight away, like an Uber Oil order. Instead, most businesses and investors use futures, a contractual agreement to pay a set price for oil delivered at a future date. Think of it as a pre-order. With oil, these futures are set up in monthly batches, so you can pre-order for any month this year, or a month of next year, 2022 etc.

Using futures is better than spot sales for the oil industry as it offers more stability and certainty. After all, you wouldn't want to invest a billion dollars in an offshore rig, tap a well, only for oil prices to drop significantly. For those further downstream, futures ensure a more steady supply despite volatile prices.

Futures are vital to other industries as well, especially agriculture, where growing crops or raising livestock may take years to pay off. Farmers can shift some of this risk to investors, meaning you can buy a contract for pigs, and the farmer can rest easy knowing he has a buyer locked in.

Futures can be traded, so investors can enter the market by agreeing to a delivery of oil (or pigs) to them personally. Then they sell the contract before delivery, hopefully at a higher price, to another investor or a business that will actually use the commodity. If you can't accept the commodity itself, the worst thing you can do is hold the contract until it expires, becoming obliged to accept delivery.

A Big Delivery

If you were to let your futures expire, you may be left on the hook for an enormous delivery. Just ask the trader at Aexecor who accidentally left some coal futures on the books until expiry. Due to his slip-up, a small software issue, and the convenient location of their offices at a redeveloped warehouse district with it's own pier, the coal was delivered.

28,000 tons of coal.

There are safeguards in place to stop this from happening, where an industrial sized shipment is delivered to your office. However, you would still own the commodity and be responsible for storage and shipping. Oil, like coal, is a hazardous material, so it would not be as simple as throwing it in the garage for a few weeks, especially 1,000 barrels or so.

Clearly, if you are going to hold futures contracts, you need to make sure they're sold before expiry. For May's oil futures in America, this was 6:30 this morning. Investors would have been scrambling to get these off of their books.

The Shutdown

America uses a lot of oil, on average about 20 million barrels a day. There is about 160 litres in each barrel. So most investors trading oil futures don't usually have to worry about selling. Usually there is no shortage of businesses willing to come to the table.

But these are not usual times. Clearly the demand for oil is way down. Fuel prices have fallen in NZ, but cars are sitting in driveways, planes are sitting on runways and businesses are not producing. The same applies across the world.

Because businesses and consumers don't have much need for oil right now, it may be difficult to find someone to buy those futures you bought last year. But surely someone is willing to buy it cheap, hold onto it and sell it on later? Worse case scenario is you just give it away?

The Garage is Full

America is running out of space. Cushing, Oklahoma, is a storage hub and delivery route for US oil. As explained by the New York Times:

Other businesses are also running out of storage capacity. The US Government has offered to pick up some surplus for their reserves, although space is tight there too. This issue is also cropping up around the globe.

What about supply? It may seem obvious to put a plug on the wells and stop producing until everyone's back at work. If only it were that simple. Oil wells are pressurised, so you can't just walk away from it, and to re-cap it can damage the well and cost alot of money. As Vice puts it:

The Trifecta

So three things led to the price dropping below zero:

1. There is little demand for oil by businesses

2. There is nowhere to store the oil being produced

3. Investors need to get rid of their futures contracts before they expire

Combine these factors and you get desperate investors doing anything to get off the hook, even paying someone else to figure out where to store the end product. What sounds unbelievable at first is perfectly reasonable given the extraordinary circumstances.

As stated previously, May's future contracts expired this morning. The price quickly rebounded from nearly -$40 to +$14, so if you had storage available, big profits would be coming your way. Clearly oil was still valuable this whole time and it was the structure of futures trading which pushed prices negative.

June's contracts will expire next month. Like how Vice mentioned oil suppliers playing chicken with supply, investors will do the same with futures. It is possible they are left on the hook for negative prices again if demand remains low and storage/supply issues are not rectified. But markets will price in this risk accordingly, which is part of the reason prices are subdued.

This month the risk didn't pay off, and hit speculators particularly hard. If the situation improves, these brave investors will be compensated for the risk they accepted (all else unchanged of course).

Lessons Learnt

Prices below zero is not an apocalyptic forewarning and is reasonable given the circumstances. While the current investment climate is uncertain, markets are behaving exactly as they should.

While low oil prices will have large flow-on effects for the entire world economy, they are one gear in a complex machine. As Jamie Gray points out in his NZ Herald article, NZ is a net importer, benefiting from lower prices. However, some oil producing countries purchase our dairy exports. Making predictions based on one factor ignores the immense complexity of world markets and economies.

A black swan event like COVID-19 is shining a light on the true risks of some investments. Oil futures provide an excellent example of this.

But other examples stand out, such as NZ real estate investment trust Kiwi Property Group, often touted for their steady dividends. The same applies for Auckland Airport, or any other airport. Purchasing shares for a steady dividend, instead of relying on payments from bonds, pushes your risk exposure further up. Only last year, something affecting "safe" companies like these was often dismissed, but nobody could have foreseen COVID-19. Now any investor purchasing shares for short-term income are dealing with the risks of owning these shares.

The dangers of speculation and concentrated investments is made clear. Thankfully, these dangers can be easily avoided with a widely diversified portfolio and a disciplined, long-term strategy. Knowing your tolerance of risk is also key, so you don't take more risk than you are comfortable with. Chasing higher returns or steady cash flows can end very poorly if you get ahead of yourself. If in doubt, ask for advice.

And, you will be happy to know, we don't include commodities in our portfolios. So don't worry about 28,000 tons of coal on your doorstep come Christmas.