If you think you have witnessed a once-in-a-lifetime event when you saw oil prices turn negative on Monday, you’re wrong on two fronts. Oil prices didn’t turn negative — it was the underlying WTI May Contract, with an expiration date on April 21, that turned negative — and it is not a once-in-a-lifetime event: it will happen again in another month.
Oh, and it will be worse.
If there’s something to be learned from all this — for Bitcoin enthusiasts, for the common man, and for the people with a minivan sitting in the driveway that’s full of petrol and longing for the open road — it’s that a quick study of supply, demand, derivatives, ETFs, dollar-denominated assets, your 401(k), and, of course, Bitcoin and other cryptocurrencies is in order. Let’s begin, because the ramifications are going to impact just about everything.
It’s actually quite simple: the oil that was ordered by holders of the WTI May contract had nowhere to go. So what started as a fire sale — hey, buy this for a few cents a barrel! — turned into a situation where contract holders were actually paying people to take the oil off their hands.
Now, before you join the cacophony of “I’ll take that oil and put it in my garage and they can pay me $37 a barrel!” cries, you have to realize a few things about these contracts:
- Only certain types of investors can actually hold these contracts: unlike other derivatives, futures contracts like the WTI ones that went nutso aren’t open to the average investor (more on what that means for ETFs below);
- They are actual delivery contracts, and this is why they are not open to the average investor;
- Yes, that means that holders have to take delivery of the physical product.
Tease this out for a half second and you’ll see why this is such a quagmire: the oil had nowhere to go.
Now you can see why this market went south in a big hurry; like a game of hot potato, nobody wanted to be left holding a worthless asset. (Not a worthless derivative that gives you the right to take delivery of a stock if you want it, but an actual tanker of oil that has nowhere to go.)
When the Coronavirus crisis started, global oil production was somewhere in the neighborhood of 100 million barrels per day. Russia and Saudi Arabia agreed to cut production by 10 million barrels a day, which helped a little when the economic shutdown started.
But, as Danny Masters from CoinShares — a former energy trader, so he knows his stuff — shared on a video yesterday, demand for gasoline (which is one of the finished products that comes from a barrel of oil) dropped 55 percent in the month of March. “A 3 million barrel drop is overly bearish” for the market, said Masters. So imagine that the oil that had been refined into gasoline got stuck; it couldn’t leave the refinery for the corner station because the corner station wasn’t selling gasoline because your minivan is sitting in the driveway. This is an order of magnitude worse: if demand is around 45 million barrels worth a day, but supply has continued apace because orders have to be filled…you’d need a cut of 55 million barrels of production a day so that the supply doesn’t completely dwarf demand.
But that cut didn’t happen.
Where Could the Oil Go?
Cushing, Oklahoma is where most of the oil in the U.S.A. gets stored. CNBC reported that, as of April 17, Cushing was 77 percent filled.
But, with the real possibility that Cushing becomes filled up — especially with deliveries slated to Cushing to satisfy May contracts AND few refineries sending tankers out with gasoline because there’s less demand for gasoline — it’s highly possible that the oil will continue to be stuck in limbo.
Reuters is reporting that Oklahoma is relaxing production rules; this will help, but won’t solve the underlying supply/demand issue. Bringing us to the June WTI contracts…
Are June Contracts Doomed?
In a word: yes.
In another few words: it’s going to get really bad again.
Tease out the above realities: Cushing was three-quarters full before all the favors were getting called in. “Can you take some oil off my hands? Can I pay you to do that? Can I pay you MORE to do that?”
While the price of the June WTI contract is hovering in the low teens right now, the guess is that no more favors will be left to call in. The Strategic Petroleum Reserves are pretty much at capacity. It will be no surprise to see the June futures turn negative again — perhaps well before the expiry date of May 19 — and, without steep cuts in drilling, this could be a monthly occurrence.
What’s the Next Domino to Fall?
USO. If you’re wondering whether or not this ETF is in trouble, consider these facts:
- This ETF is down 80 percent this year.
- Rules governing the fund’s investments needed to be changed as a result of the WTI May Contract Freefall. The fund was slated to invest just in the next month’s contract and attempt to replicate its gains or losses; once the WTI went negative, then dramatically so, the fear was that continuing to track against a negative balance would be untenable at best and cataclysmic in a worst-case scenario.
We’d stop short of saying this is “the perfect short,” but a crazy-volatile investment that goes negative can only lead to borderline insanity. Beyond that, with “Stay at Home” orders continuing, demand in the month of April — remember, people didn’t start facing these quarantine conditions until March 11 at the earliest — will likely fall below the demand for the month of March. The glut will not be solved without turning the oil pumps off completely. It’s a shock to the system — only the large oil companies will be able to weather the storm.
We could be wrong — the rules to change the calculation of the ETF’s investment is a good step — and the fund could bounce back. But we’d stay far away.
And…What — If ANYTHING — Does This Have to Do with Bitcoin?
Back to the Danny Masters CoinShares interview, as it uncovered a couple of interesting ideas. In part one, Masters tells host and CoinShares colleague Meltem Demirors about the underlying conditions leading to the negative oil. Demirors counters with an interesting concept:
“People thought they were buying an asset, but instead they were buying a liability.”Metltem Demirors, CoinShares
Here’s the first part of the interview:
So if you think about Bitcoin — and other cryptos — within the concept of buying an asset vs. a liability, there is a near-zero chance that someone will ever pay you to take their BTC off of their hands. Crypto is an asset, not a liability. And the need for an asset AND a digital currency — especially in a “contactless” community that we’re all in the process of joining whether we like it or not — will only grow in the months to come.
But that’s not the most telling piece of this interview; that comes in part two, which you can watch here:
Demand for oil is low.
Demand for Bitcoin is steady; with the upcoming “halving,” when the rewards for mining a block are cut in half, fewer Bitcoins will be released into the wild. Masters, in the interview, thinks that “HODLers” (like him) won’t get rid of their BTC until it’s closer to $10,000.
And large funds lock up people’s BTC — Greyscale’s fund, for instance, has a lockup that lasts about a year — so people aren’t going anywhere anyway.
Finally, Volatility and the Brrrrrrr Factor
Oil will be volatile for sure. Bitcoin already is volatile, has been volatile for some time, and should continue its volatility for the foreseeable future. Oil traders are not used to what they’ve seen this week; Bitcoin traders yawn (and aren’t going to see negative Bitcoin ever).
But the Fed’s role in all this can’t help oil supply — only an economic rebound that gets people driving again will do that — and is more than likely to seriously help the Bitcoin market considerably. The Fed’s ability to print money and do some sort of quantitative easing at the drop of a hat can only mean that the long-term prognosis for some sort of anti-dollar is nothing but strong.
Our advice: buy whatever you can, within reason. Good luck.