Not theory, reality - The world of negative oil prices

Studying advanced microeconomics often requires learning to work through special cases of extreme behavior like negative prices. Counter-intuitive thinking is often required, but the process provides a deeper understanding of price dynamics and thinking out of the box. Now, we are living in world where negative prices are a reality. This is not just manipulation of rates by central banks but private market dynamics. Think of all the grey hairs given to risk managers. Yet, the price dynamic we are seeing are not irrational. 

The negative prices for May front-month futures at contract expiration, while surprising and not normal, make sense in an oil world of extremes. This can be explained through number of economic channels, production and producer behavior, inventory, and future contract construction. When all of these effects move in tandem to drop prices, there is no floor at zero.

One of the most interesting research papers on exhaustible resource over the last few decades has been "Hotelling Under Pressure" published in one of the leading economic journals (Journal of Political Economy). It refutes the Hotelling theory of exhaustible resources which describes the behavior of miners in the face of changing prices. "Hotelling under Pressure" shows that oil is different than other exhaustible resource because it is not lifted from a mine like gold but propelled to the surface by pressure. The long and short of their work is that oil production is not sensitive to price. Prices may fall and there will be cuts in drilling, future production, but not current production. Oil coming out of the ground will not be turned-off.  The supply will keep coming. We are living in a world where oil production will not be shutdown.

For storable commodities, there is a safety valve from holding inventory. When there are low prices today, commodities can be held in inventory until tomorrow. If prices are high, they can be smoothed through taking the commodity from inventory for sale today. Price extremes can be avoided at least until there is a no inventory available, then all of the supply or demand shock has to be displayed in spot or the nearby futures prices. No storage with continued production, there is no place to put the oil. At the extreme, a producer will have to pay someone to take the oil. It is not a choice but a requirement.  

These price dynamics see further extremes when demand and supply are inelastic. With simple microeconomics, the volatility of any commodities is directly tied to the price inelasticity. Oil production does not change with price in the short-run, and if normal demand for refined products falls, there is no place else to go with the production. No driving, no demand for gasoline, and no demand for crude by refiners. It cannot be used for some alternative purpose. 

We then come to the place where all of these issues must be resolved, the expiration for a futures contract with delivery at specific location, Cushing Oklahoma. Long positions have been closed or rolled to future contracts before expiration or receive delivery of oil. There is no cash settlement. You can call it a squeeze or corner, but if you are short futures, you may want to deliver oil, but longs have no place to hold oil. Longs will sell at any price to get out before expiration, even at negative values. The cost of taking delivery is prohibitive, so the market clears at levels where buyers are paid to take oil. The price is based on ability or inability to store and expectations of whether there will be market participants to take the other side of the futures trade. The day of reckoning is at expiration. Hopes, fears, and reality meet contract terms. 

Can it happen again? Yes, but since we have a new reality, any extreme price crunch will be realized sooner yet may be muted because all traders will know it is possible. Unfortunately, these extreme events compromise the use of the oil futures market.