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Crude Awakenings

Published by: Nathan Smith Date: April 24, 2020

The country continues to try to curtail the spread of the coronavirus by forcing non-essential business closure, social distancing, and the halting of large gatherings. The effects are starting to show up in the economic data as unemployment figures, housing starts, industrial production, and demand for crude oil have all been adversely affected. This week, in particular, saw trading in crude oil that many (including myself) would have never thought possible. The contract for May crude oil (chart below) actually traded negative. Negative prices have happened before in propane and natural gas, but to see this occur in oil left everyone scratching their heads, wondering how this could happen. In the days following the wild trading in crude, it appears that we have uncovered the answer, and it involves a group who many want to believe are the most “sophisticated” investors in the world, aka the hedge funds.

Hedge funds are those mythical beings that promise exclusive access to markets that mere mortals like ourselves aren’t allowed. They will speculate on anything, and everything they believe could generate oversized returns for little risk. Some of these funds found out the hard way the importance of knowing what you are investing in and what can happen when you don’t. The funds were buying oil betting on a rebound after the price went down 50% from the economic shutdown. When prices failed to recover, they decided to try to salvage their positions by taking delivery of crude oil and selling it later in the year at a higher price to recoup their investment. But unbeknownst to them, all the tanks in Cushing, Oklahoma, where the crude oil contract is delivered were almost full, and no one was willing to sell them any storage space. The lack of storage caused the funds to sell their positions, and by the end of the trading day, forced them to pay others to take their oil contracts. It would appear larger oil companies that had some remaining storage caught wind of these funds and their predicament, and made a nice profit from their lack of awareness.

The oil market is indeed weak right now due to the excess supply from the economic shutdown. But, the movement in price we observed this week was a one-off event that should resolve itself over the coming months as economies come back online, and supply and demand find an equilibrium.

The key takeaway for us “average” investors is that when we are speculating, there is a real possibility that you could suffer a complete loss on your investment. Speculative bets should be with dollars that an investor is willing to lose and not next month’s house payment or something more substantial that could prove detrimental to the outcome of your long-term financial plan. Given the recent performance in oil, cruise ships, hotels, airlines, and drug manufacturers, investors may be enticed to buy these stocks, thinking that the worst is behind us. But if you don’t understand what you are invested in and take too much risk in one individual stock or market segment, you could be in for a crude awakening if and when extreme price events happen.