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Beyond the Negative Headlines: Oil Prices Aren't What They Seem

By Matthew DiLallo - Apr 21, 2020 at 7:15AM

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While near-term oil futures contracts plummeted into negative territory, those that expire in later months aren't quite as dire.

Oil prices grabbed headlines this week as front-month oil futures contracts (i.e., those expiring next) for two key pricing benchmarks crashed and burned on Monday. The May futures contract for West Texas Intermediate (WTI), which is the main U.S. oil price benchmark, cratered to a jaw-dropping negative $38.52 a barrel. Canada's main oil benchmark, Western Canadian Select (WCS), also went negative.  

However, beyond those headlines, the oil market told a different story. Here's a look at why those contracts gushed red while others held up relatively well. 

A barrel spilling oil on $100 bills.

Image source: Getty Images.

Paying people to take delivery of crude oil

Oil futures contracts require that the holder take physical delivery of the oil upon expiration. That's usually not a problem because a trader can flip the commitment to a buyer that has access to storage and roll the proceeds into a new contract with an expiration farther into the future.

However, because of the COVID-19 outbreak, global oil demand has cratered, and crude is piling up in storage. At the current pace, the U.S. will run out of room to store oil by the middle of next month. As a result, storage costs have skyrocketed.

This situation has put oil traders in a bind, especially with May contracts expiring on Tuesday. No one wants to buy oil for delivery next month since there's nowhere to store it. That's leaving oil traders with no choice but to pay to unload their contracts and avoid having to take physical delivery, which would cost money since they'd need to pay the pipeline shipping costs as well as storage expenses (if they can find room). 

Other oil contracts tell a much different story

While May's contracts for WTI and WCS made headlines for their historic plunges into negative territories, other oil contracts held up much better. The front-month contract for the global oil benchmark, Brent, -- which doesn't expire until June -- only declined by about 7% on Monday and was still in the mid-$20s. Likewise, the June WTI contract kept its head above water as it closed around $21 a barrel on Monday. Meanwhile, later dated WTI contracts (starting with September) fetched more than $30 a barrel. 

This massive disconnect between near-term prices and those farther out is why most oil stocks barely sold off on the historic plummet in WTI. Instead of focusing on the negative headlines, investors see some light at the end of the tunnel in that oil producers around the world are slashing output to help address the industry's glut. OPEC, for example, partnered with several non-member nations on a historic 9.7 million barrel-a-day (BPD) reduction that will start on May 1st.

Meanwhile, several producers in the U.S. and Canada are shutting in wells because of the region's infrastructure issues. ConocoPhillips (COP 2.38%), for example, plans to reduce the output of its Surmont oil sands facility in Canada by 100,000 BPD by May. ConocoPhillips also expects to start shutting in wells in the U.S. next month, curtailing another 125,000 BPD. Fellow U.S. producer Continental Resources (CLR 0.06%) is also reducing its production, slashing it 30% in April and May. One factor driving that move is that a refining customer of Continental asked the company to reduce the oil supplied to its facility in Oklahoma by 25% because it didn't have room to store the finished refined products.

More producers in the U.S. and Canada will likely announce production reductions in the coming days to help ease the industry's infrastructure issues. Those in Canada, for example, could curtail as much as 1.7 million BPD -- or a third of the country's total output -- since there's nowhere for this oil to go.

The oil futures market sees these production cuts as eventually helping ease the glut of oil piling up in storage because it will bring supplies below demand. That should allow the economy to begin burning off some of the excess inventory once governments lift restrictions put in place to slow the spread of COVID-19.  

Musical chairs: The oil market edition

With the May contracts of WTI and WCS nearing expiration, it forced oil traders to unload positions so that they didn't have to take physical delivery next month. With storage space at a premium, their only option was to pay someone else to take the oil off their hands.

While that technical issue made for some splashy headlines, the broader oil market largely shrugged it off since producers are slashing supply, which will hopefully alleviate some of the storage issues in the coming months. However, that doesn't mean the June WTI contracts won't also go negative as they near expiration a month from now. Nor does it imply that oil stocks are out of the woods since crude prices in the $20s and $30s are still well below the level most producers need to survive. Because of those factors, the worst likely isn't over for the oil market.

Matthew DiLallo owns shares of ConocoPhillips. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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