Explaining a historic collapse for oil prices
It doesn’t seem to make sense for oil prices to be negative, but that’s exactly what happened in April.
In April, oil prices made history by dipping into negative territory. What does it mean when oil prices are less than zero?
The oil price implosion
Oil prices plummeted once the COVID-19 pandemic started shutting down economies. Travel, commutes and transportation in general came to a screeching halt. Once-busy corridors began to look like ghost towns. Demand for oil was the lowest it has been in recent memory.
Prices began significant daily drops on Feb. 24, when WTI oil dropped 3.5% to $51.43 per barrel. By March 5, WTI was settling at $45.90 a barrel. These decreases were a result of COVID-19, for the most part.
The problem has been exacerbated by an oil supply glut, both domestically and globally. On March 6, the Organization of the Petroleum Exporting Countries and its allies, including Russia, failed to make a deal to reduce oil production. Also known as OPEC-plus, the group’s lack of a deal led to oil prices getting cut by a full third within two days, to $31.13 per barrel.
A 25% decrease on March 9 alone was the largest one-day drop since January 1991. Back then, oil prices plummeted by 33% as a result of the first Gulf War. Despite ultralow demand, oil producers continued to pump out just as much oil as before.
From there, the situation just got worse, with a few spikes in prices slowing the inevitable downward spiral. As prices kept sinking, they finally hit what investors refer to as the “psychological threshold” – i.e., prices below $20. On April 15, WTI oil settled at $19.87, the lowest since 2002.
Despite the freak out at the time, sub-$20 would pale in comparison to what was about to come just a few days later.
From cool to subzero within hours
April 20 was the final day of the May contract for WTI oil. In other words, that was the last day oil producers could sell barrels scheduled for delivery in May. Demand for oil had only gotten weaker. No one needed or even wanted the oil. Consequently, history would be made.
Early in the trading day, WTI May contract oil prices began to sink at breakneck speeds. By 11 a.m. Eastern time, investors and analysts were already freaking out as prices had dipped to $10, the first time since 1986. At noon, the near-record low started sinking further, hitting below $8 at 11:34 a.m., then $5 at 11:52. Just after 1 p.m., WTI hit $0 for the first time ever. That’s when the floor was erased out of existence.
By 1:30 p.m. on April 20, WTI oil prices hit a record low of negative $40.32, eventually settling at negative $37.63 for the day. The 306% freefall is the largest intraday decrease ever.
What do negative oil prices mean?
When oil traders sell oil, they are selling it ahead of time for delivery on a certain month. As noted, the record-low price came on the last trading day for the May 2020 contract. That means traders were pricing oil to be delivered in May.
However, a combination of low demand due to the coronavirus pandemic and the deal reached by OPEC-plus being underwhelming meant that the oil already bought was not going anywhere. Essentially, there was already so much oil not being used that there was nowhere to store even more barrels. Consequently, no one wanted the oil being delivered in May.
When oil is in demand, traders will pay X-amount of dollars for contracts, knowing barrels will get snatched up to keep up with demand. When there is a supply glut, fewer barrels are needed. Therefore, the price goes down. When there is a supply glut and something causing unprecedented low demand, no barrels are needed since those storing them cannot get rid of them fast enough.
Oil traders still need to somehow get rid of those barrels from which they bought contracts. This wraps us back around to the negative prices. Rather than getting paid for the barrels, the market suggested that traders would pay people to take that oil off their hands. Pay them more than $40 per barrel, at one point. Not only did traders have nowhere to store oil, but neither did buyers, such as refineries, airlines and other companies that have massive storage facilities.
Effects of the oil collapse
Despite the chaos, people shouldn’t expect a comparable decrease in fuel prices.
According to the Energy Information Administration, the price of crude oil accounts for less than half the amount we pay per gallon for on-highway diesel fuel. More than 20% pays for marketing and distribution, another 18% pays federal and state taxes, and another 15% covers refining costs and profits.
Assuming a national average of $2.40 per gallon of diesel that comes to 50.4 cents a gallon in distribution and marketing, 43.2 cents in taxes and 36 cents in refining costs. Completely eliminate the cost of crude oil and you’re still paying a bare minimum of $1.30, and that does not include sales or local taxes and other external factors.
As local, state and national economies slowly reopen, demand for oil will follow suit. What we saw in April could only happen if all the stars in the sky are perfectly aligned, which they were for one day. There’s a chance we’ll never see this again, no matter your age. LL