It is a very ill business wind that blows no economist at least some good.
That certainly was true last Monday, when oil prices reportedly reached a negative $37.63 per barrel. In other words, if you had a barrel of oil you did not want, you had to pay someone that much to take it off your hands. That prompted queries to economics professors and pundits. How can there be a negative price for oil? When will filling stations start paying you to take 20 gallons of gasoline out of their tanks? Is this a “market outcome?”
The questions are good. The details are a bit different from the headlines. The minus-$37.63 price was not for a physical barrel of oil somewhere, but rather the price at which someone who earlier had entered a futures contract could get out of the financial commitments that contract entailed.
The two — cash payments for barrels of physical oil and prices for oil in contracts traded in financial markets — are related. Both are driven by underlying conditions in the real world. More oil is being pumped than is used. Nevertheless, pumping continues. Very little available oil storage remains. Something must give. The negative price was a temporary anomaly, but real, physical oil is selling at prices unimaginable only months ago. This glut will not soon disappear, and that is grim news for North Dakota and Texas, in particular.
Start with the futures contract situation last Monday.
Explaining the history and logic of futures markets could take several columns. Accept that they are legitimate risk management tools, just like life insurance or homeowners’ insurance. They allow people to protect themselves against possible adverse events. Standardized contracts for the purchase of a specific product, quantity, quality, location and at a specific time in the future can reduce the risk both for buyers and sellers even if the particular good one produces or uses is somewhat different.
As long as such differences are predictable, using futures can be beneficial for both sides, purchasing or selling, whether for wheat, aluminum ingots or crude oil. Standardized contracts are traded on organized exchanges with a “clearing house” interposed between any two particular parties. No individual trader has to sue her counterparty in case of default. And thousands of identical contracts trade each day.
Enter into a contract when you want. Later, you can get out of it by making and equal and opposite trade at a time that suits you. If you contracted to deliver 5,000 bushels of No. 2 yellow corn in May for a certain price, simply enter into another contract to accept delivery of and pay for 5,000 bushels of the same corn in the same month.
The two positions offset each other. You have no net obligation to anyone. And, as long as the specific product you handle maintains the usual relationship in price to the standard contract one, you are protected against adverse price moves.
While millions of people, including many readers, may continue to see this system as corrupt and exploitative of society in general, futures markets can foster more efficient use of resources in an economy, just as personal or business insurance does.
However, many devils lurk in details. A commodity futures contract is a legal commitment to deliver a specific product at a specific point at a specific time. Unless you “close out your position,” by making an exact off-setting trade, you must comply or face consequences.
Only a miniscule fraction of futures contracts result in delivery. A farm co-op elevator in Worthington, Minn., may enter into hundreds of futures contracts that benefit its farmer-members without ever dispatching a semi-truck or railroad car of corn to Chicago. A trader like Cargill or CHS may hold futures on millions of bushels without any bushel ever being delivered to settle a contract. All these businesses simply offset their positions when convenient and then sell or buy the actual grain they need in the cash market.
All hinges, however, on the existence of a liquid market that participants can exit smoothly. Buyers easily can find an off-setting seller and sellers an off-setting buyer.
That broke down on Monday. The following day, sellers with open contracts for May could start forcing delivery on buyers with open contracts by delivering crude at the contractual delivery point of Cushing, Okla., a pipeline and storage hub.
Here the specifics of petroleum as a commodity enter with a vengeance. If necessary, corn could be piled on the ground. Myriad farmers feed it. If you owned unwanted corn in Chicago you could give it to a farmer or, at very worst, you could pay to truck your cork to a landfill.
But no one without an oil refinery can use West Texas Intermediate crude. It cannot be piled on the ground, or kept in refrigerated warehouses like cheese or pork bellies. Building tanks takes money and time, so does refining oil into gasoline. Oil is polluting, so it cannot be landfilled, composted or plowed under.
Thus, if you have a legal obligation to take it or face harsh penalties, you must pay someone else to take it off your hands. The price that needed to be paid to accomplish that got as high as $37.63 on Monday. That was the “negative oil price” we all read about and drove the larger securities market indexes sharply down. It doesn’t mean that people will be paying others to take their oil every day going forward, or that filling station owners will be waving $20 bills at passing drivers to entice them to come in and take unwanted gasoline.
It is, however, evidence of the profound changes that have occurred in world energy markets. Some, including minimal household purchases of gasoline while we all shelter in place, will taper off. Ditto for the sharp fall in airline travel. Both driving an flying will eventually pick back up.
But other changes, including in the production capacities of Russia and the Persian Gulf countries juxtaposed against their governments’ spending patterns, are not going to go away. And that means that the reviving U.S. oil industry will face harsh choices.
St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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April 26, 2020 at 09:09PM
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Real World Economics: Temporary blip signals long-term problems for oil - TwinCities.com-Pioneer Press
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