At the same time the other benchmark, a North Sea oil called Brent Crude, traded at some USD25, i.e. here oil still cost money. A day later, Brent Crude has dropped to USD15.98, a low not reached in real terms (after inflation) since the 1930s.

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Why did West Texas Intermediate turn negative?

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There were two reasons:

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One is that the price is measured in Cushing, Oklahoma which is a town with huge oil storage facilities in the middle of the US – the closest harbour is Galveston which is 900km away. Those storage facilities were full – any storage available was already committed for other deliveries – so those with oil had to pay enough to get rid of the oil in Cushing when there was no storage.

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Also all the pipeline capacity was committed, so that only left one option: Trucks. To transport large quantities of oil by trucks is expensive, and, since the oil was not needed at all and worth very little, the vendors had to pay all the truck expenses and got no money for their oil.

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Why would anybody sell oil for very little or nothing at all? After all, it costs money to pump for oil even from an existing field? One reason is that, once you plug an oil field it is usually expensive and often impossible to re-start pumping oil from that field. Hence many people just keep the oil flowing and until yesterday, they at least didn’t lose money and could always hope for better times in the future.

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The second reason is a really interesting one:

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If you want to invest in physical gold or oil without taking delivery of the actual gold or oil, what do you do?

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You buy what is called an Exchange Traded Fund (ETF) that then buys and stores gold or oil on your behalf. That is not a problem with gold as it is easily stored, however oil is quite a different story.

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The Oil ETF (its stock ticker is USO) until yesterday bought oil for delivery in one month and, a few days before that month expired, sold the delivery contract (it is called a futures contract as delivery is in the future) and bought another contract that is again one month away.

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Normally that works very well as the price for oil for delivery today is very similar to the price for oil in one month.

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However, if there is nowhere for oil to be stored, oil for delivery today is worthless (or costs minus $40), while oil for delivery in a month still has a value.

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Therefore the Oil ETF loses a lot of money every time it has to sell a contract and buy another a little in the future.

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It was quite predictable that Cushing would run out of oil storage. It happened about two weeks earlier than anticipated, but with far fewer people driving, more oil is being produced than consumed.

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So why did we have this market dislocation for West Texas Intermediate oil two days ago and further steep falls in other countries yesterday?

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The oil specialist of The Financial Times (Izabella Kaminski) actually isn’t sure. The most likely explanation is that a lot of retail investors saw that oil was very cheap and thought “I will buy some”, not knowing how the Oil ETF works and being completely surprised by the dislocation yesterday.

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In other words, in times like these there can be great bargains to be had but not everything that is cheap is a bargain.

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Another much more technical explanation that is offered – and is also quite plausible – is that many hedge funds want to invest in oil (buying or selling) for just minutes, hours or a day or two. This presents a money making opportunity for the people who manage the Oil ETF by creating ETF shares, selling them and buying them back within a day or two. That strategy backfired yesterday.

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In any case, quite a few people made very large losses yesterday and we will find out over time who got caught and also who made a fortune yesterday.

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During wild times like these a lot of past assumptions turn out not to be true. A big part of my job is to find these wrong assumptions during good times and to steer my clients away from them.  During difficult times like these there is also plenty to do – monitoring very carefully what is happening day to day and offering advice and help for all clients.

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Examples for being alert during good times are life insurers I feel a little less comfortable about, or industry funds that take on too many illiquid assets and then have to sell their liquid assets (their shares in listed companies like BHP or Transurban or Westpac) during a downturn in order to meet the unexpected large scale super withdrawals that the government allowed (the $20,000 per person early release amounts).

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Feel free to call me at any time if you have any questions or would like any clarifications.

Warm Regards,
Christoph Schnelle
 

AFP LRS Adv. Dip.FS (FP) MBiostats

Life Risk Specialist GStat Graduate Statistician

SMSF Specialist Advisor

Accredited Aged Care Professional

Accredited Estate Planning Professional

Authorised Representative 308223