You have most probably noticed that we are living in strange times at the moment. In fact so strange that the oil was trading at negative prices just a couple of days ago. Let me explain everything you need to know about this 2020 oil crisis.
We will find out what is the USO, what are oil futures, how do they work, what is a commodity contract and so on.
What is Crude Oil
Let’s start from the beginning- crude oil is the raw, unrefined oil material. It is the thing that comes from the oil wells. In this form it’s toxic and cannot be used for anything. But it can be refined to make diesel, petrochemicals, asphalt and many, many other things.
How Does the Oil Industry Work
Here is how it goes- oil is drilled from the ground by oil companies to extract crude oil. This crude oil is then processed by refineries and sold to different markets across the world. This is the simplest explanation possible, we will get into more details in a minute.
The Commodity Market
Here is where it gets interesting- crude oil is a commodity. So the price of it is the same across the markets, which makes sense. The same as a soybean or a gold coin. It’s the same gold coin, no matter where you get it from.
This commodity is traded on the commodities market. The commodity market is something really useful for those industries. It connects producers with distributors quickly and efficiently. Also the price is moved by supply and demand, which makes for efficient price discovery.
And yes, that is correct, but only in theory. In reality 90% of the traders on those exchanges are speculators. What that means is that they only trade based on price fluctuations, so they can make a short-term profit. They have no intention to buy the physical good, their only intention is to sell to a higher bidder.
But as there are real producers and real distributors there, the commodity markets trade in futures contracts. What is that you may ask?
The future contract is a legally binding contract that you agree to buy a certain good at a certain time for a certain price. If you buy let’s say a crude oil contract for the month of July you are now legally obliged to take that shipment. Which means that there will be an oil tanker in July, waiting for you to take your delivery.
This contracts come to fruition by the end of every month. So if you are holding a contract for the end of the month, the contract is legally binding and you have to take the physical delivery of the product. Of course every paper trader exits their position before the time comes, so they don’t have to accept the physical delivery.
And more importantly- because they can’t take it. After all crude oil is not something you can just take in your backyard. It is toxic, highly dangerous and you need to be in this business to know what to do with it.
The USO
Here is where it gets even more interesting- in the crude oil markets we have this thing called the United States oil fund, or the USO. It’s name suggests that it is an oil fund that tracks the price of oil. Which makes people believe it’s an ETF. Well, it’s actually not. It’s an exchange-traded product, or an ETP.
The difference is quite big. An exchange traded fund trades in paper instruments, such as stocks or bonds. But this ETP trades in oil futures contracts.
What they do is they buy a basket of oil futures contracts for the next 4 months. But the USO is an instrument and they cannot physically take oil deliveries, or store crude oil somewhere. So what they do is they roll over their contracts every month to the next one. In other words they sell their contracts to a bidder that will actually take the physical delivery of the crude oil.
This is ok in normal conditions I guess, but things get complicated when oil storage is at capacity. When we have a capacity of oil, those physical distributors don’t want to buy anymore oil, which leaves the speculators fighting for a place to get out of their contracts.
And that fighting leads to what we saw recently- oil prices going negative. As it turns out when supply outpaces the demand and the oil prices can indeed go negative. But why is that?
Oil Market Landscape
Well, because unless many other goods, it’s not so easy to just stop pumping oil. It costs a lot of money to stop those oil drills. And also they cannot operate at under 60% capacity. So for oil producers it’s actually cheaper to just keep pumping than shutting down.
But things start to get tricky when we look at the supply and demand of oil. Let’s take a look at the supply side first.
What we are seeing is a sharp increase in supply of US oil with the boom of shale production. This sharp tick in supply is so much, that it actually far outpaces the demand for oil. Which of course brought the oil price down over the last decade.
And when we have too much oil, we start having build up of reserves and storage. The problem is there is only so much storage. And things can get very tricky once storage runs out. Let’s take a look at the demand vs supply side of things.
Here we see the global oil supply and demand. As you can see we had stock build far before the global shutdowns. In fact from the last 5 years we only had 4 quarters, where oil demand outpaced the supply.
And if we look at Q1 and Q2 of 2020, the difference between supply and demand is staggering. And in Q1 we didn’t have worldwide shutdowns for the most part.
Let’s take a look at another graph.
As you can see the non-OPEC production is continuing at the same pace as before. This, again, causes for build-ups of oil. Let’s take a look.
This is maybe acceptable in a short amount of time, but the big problem is that the US oil capacity is starting to fill up. You can check the stats here.
What we are seeing is something very interesting- the total storage capacity is at 50% in the beginning of March, before all the worldwide closedowns. And as of April 17th is at 60% , with Oklahoma now being as high as 76%.
What is more interesting is how quickly the capacity is getting filled. Cushing, Oklahoma raised their total storage from 54% to 76% in just under three weeks. Or in other words- somewhere between 7 and 8% in a week. If we do the math we can see that the Oklahoma storage capacity is going to be filled somewhere in the beginning of May.
Then we have the total storage capacity of the US, which is at 60% as of a week and a half ago and filling with 3% every week. If the trend continues the US will have no more space to store oil within two months.
Oil Supply And Demand
Now let’s get back to those futures contracts. What happens when an oil company produces a barrel of oil and want to sell it? They sell it at the futures markets for the highest price, which means 4 months down the road.
And when someone buys a contract they accept the delivery. Which means the oil is ready to be shipped when the time comes.
And what happens with this contract- it goes back and forth between speculators and funds. Then in the end being bought by a physical processing company, that gets the physical product shipped.
But what happens if there is no physical buyer in the end? Well it happens, what happened recently- the price goes negative. Or in other words speculators are ready to pay money, so someone can get the oil contract out of their hands.
And this way oil producers will produce as long as there is someone to buy that oil in the futures markets. The storage is not their problem. The problem goes to anyone holding the contract- physical processors, speculators or ETPs- it doesn’t matter. As long as there is someone buying that contract the producers will produce the oil that they have bought.
As I said it is actually cheaper for oil drillers to sell the oil at a loss than to stop the wells altogether.
What Comes Next
Of course, no one can predict the future. But we can see the trends and make an educated guess. As we concluded the total US capacity can take around 2 months with the same supply and demand issues. Of course, we expect to have the economy open maybe within a couple of week and that is true.
But let’s take a look at EIA forecast once again.
Here is one thing that I don’t agree with- they expect the global oil demand to be at the same level as before somewhere between Q3 and Q4. I don’t see that happening.
Do you believe we will have the same level of cruise ships, if any, running around in July? Or that we will have the same level of tourism and international flights in July? Or the same level of international trade, or construction?
Another thing is that the US producers have no intention of lowering the supply, as long as there are people buying the futures contracts. Which means that the US reaching peak capacity is quite possible within the next 2 months.
What is more interesting is what the US administration is doing- Trump’s solution is to just bail the oil producers out. But that causes an even bigger problem. This way they keep those shale companies producing, by artificially keeping them afloat.
So what are they going to do? They are going to continue pumping oil, even at a loss. After all the government and the Fed are going to bail them out, so they can just continue pumping oil.
And the Fed might be used bailing out businesses, but the current oil crisis is different. It’s a logistical crisis that can turn into environmental one. I mean what happens after storage runs out, but oil companies keep pumping oil? And crude oil is not a product you can store anywhere.
My take is that the US government need to do the exact opposite. They need to let some part of the US shale business go bankrupt, so they can reduce the supply of oil. That’s how free markets are supposed to work. But I am not an expert, so we will see how it all goes in the end. Now let’s take a look at the USO.
United States Oil (USO)
We talked about the USO, but let’s now take a deeper look on what problems might be lying there. So first things first- the USO does not hold physical oil storage. They are a speculative fund that only trades in the paper side of the futures. They hold a basket of oil futures for the next 4 months.
At the moment they hold futures for June, July, August and September. They managed to get out of their May contracts in the last days before they become legally binding. But now we have even less storage capacity, even less buyers, which of course brings the June futures down. They are already at around $11 today.
So for everyone wondering- no one knows exactly what is going to happen and I can’t predict the future. But what I know is that the USO was not designed to deal with such a supply and demand crunch. In normal times they can just roll over their contracts to the highest buyer every month.
But what happens if there is no buyer? What happens if no one wants to talk those contracts from them? The answer is that there will be retail investors stuck with holding legally binding contracts for physical oil delivery.
But where it gets even more complicated is here- what happens if all the futures prices go into the negative? Honestly, at the moment we are in deep uncharted territory for oil prices and the USO.
Retail Investors Role
The USO is in the top 20 most popular stocks of Robinhood . Which shows that there is an interest in the product from retail investors. For those of you unfamiliar- retail investor means regular, non-institutional investor, like you and me.
What is the problem is that a lot of those people are not sure what exactly are they buying. A lot of them think they are buying an ETF that follows the price of oil. But in fact they are getting exposure to physical oil contracts. And as I said in normal times that might not be a big problem.
But it can become a problem when the storage runs out and we don’t have buyers to take the delivery of the oil.
My Advice
My advice to you is to be really, really careful with USO. Know that you are not just buying an ETF, but an ETP that can have legally-binding consequences if things go south. If I was you I will not touch such products at all. But if you really want to trade oil, please wait a couple of months before you do so.
Especially in the next couple of weeks we can have a big storage problem and you might end up in a tricky situation, holding a contract.
What That Means for Oil Stocks
Most probably some of you either have oil stocks, or are looking at buying into oil stocks. In fact I have some oil stocks in my portfolio. So here’s the thing- the current situation as of today is unsustainable for oil. This of course will most probably bring a lot of bankruptcies in small oil companies, or ones with a lot of debt.
And that is the natural thing with capitalism. We have oversupply in oil, so it’s natural to have a lot of oil companies to shut down for good.
I believe the big oil majors will get out of this eventually. But be careful and don’t go on a buying spree just yet. We are yet to see the effects of storage capacity and negative oil. My advice is to wait and do your research. And again- don’t make rash decisions. Just because oil is low now doesn’t mean it will not be low in the near future.
Not saying you shouldn’t invest in oil stocks at all, but just be careful and take your time before buying in.
Summary
If there is one thing to take away from this whole thing- understand that we are now in unprecedented times in the oil industry.
I see a lot of people that want to get in on that whole oil action. And that’s why I spent a lot of time creating this guide. I don’t want you to take rushed and uninformed decisions. Hope you now understand how the oil industry works and can take a better decision for the time being.
Thank you all for reading, hope you found this article valuable. Please share this with people around you that might be making an uninformed decisions . Make sure they are well informed before they decide to put their money in the market, especially in the commodity market.
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