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  • A commodity (crude oil) that was once trading at 140 dollars suddenly became so worthless

  • that you couldn't even sell for free.

  • On the 20th of April, oil price crossed the zero dollar mark and went as far as negative

  • 40 dollars.

  • Some people got excited since they were expecting free gas at the gas stations.

  • Some went as far as imagining that they will be paid to buy the oil, which sounds a bit

  • strange.

  • To understand the current crises, we have to have some clarity on how crude oil prices

  • work in the first.

  • Like any other market, you would assume that the laws of supply and demand drive the price.

  • Oil producers on one side such as Saudi Arabia, Russia, UAE, and others.

  • And a dozen major consumers on the other side such as the US, China, and India.

  • So if suddenly these countries would no longer want the oil, the prices would decrease and

  • vice versa of course.

  • Oil producers can also manipulate the price based on how much oil they would supply the

  • market.

  • But here is the problem with the oil market.

  • Sometimes the demand can rise, but the price drops, which doesn't make sense using the

  • laws of economics.

  • And that it because oil prices do not often work with supply and demand but are more driven

  • by what happens in the financial market.

  • Yes, those dudes in the wall street with fancy suits quite often have more influence over

  • the oil prices than oil produces themselves.

  • This industry is really competitive, and it's not easy to get into it.

  • You can't simply drill oil under your house and start selling.

  • It's mostly governments, or government-controlled companies who are producing the crude oil

  • and risks are high, like really high.

  • Imagine spending millions of dollars extracting crude oil from your soil.

  • Then ship it to your client, who is thousands of miles away, and then find out that oil

  • prices have dropped.

  • In fact they dropped so low that selling this oil is just unprofitable or worst.

  • You have to sell it at a loss.

  • To prevent such things from happening and be confident that regardless of what happens,

  • the buyer will buy your crude oil at an agreed price, you make a contract.

  • Let's call it a forward contract, where both of you agree to buy and sell a particular

  • asset in this case, crude oil at a specific price and on a specific date.

  • Whether the price of oil increases or decreases, it doesn't matter, the seller has an obligation

  • to sell the oil at an agreed price, and the buyer has to buy at an agreed price

  • - The Rich dudes from wall street But on the other side of the sepctrum, there

  • are speculators.

  • These are the rich dudes from wall street who are trying to make money by speculating

  • on the prices by buying and selling futures.

  • A future is a contract pretty much like a forward contract except its often not delivered.

  • And it is traded in the market like a stock and base on what's happening in the oil

  • industry, the price of the future changes.

  • Let's say Mark is a trader and wants to speculate on the price of crude oil by entering into

  • a futures contract in April with the expectation that the price will be higher by September.

  • The September crude oil future contract is trading at $40 dollars right now in April

  • and Mark buys the future.

  • The contract is worth 40 thousand dollars since oil is traded in blocks of a 1000 barrels

  • (price ($40) x quantity (1000 barrerls)).

  • Fast forward few months and its September and the end of contract is approaching.

  • Lucky for Mark, the price of the oil has increased to 52 dollars so the future contract he purchased

  • for 40K now worth 52K.

  • So he sells the contract at that price and makes 12K in profit (40K - 52K) but if the

  • prices had fallen to 35 dollars for example, he would have made a loss of 5K dollars.

  • Simple, right?!But from April to September, the price of the oil fluctuates so does the

  • price of this future and Mark can sell it any point.

  • Futures allow investors to use leverage to trade with oil without physically dealing

  • with it.

  • Lets say oil prices are 20 dollars and you expect them to increase next month.

  • Such a contract worth 20K dollars (20$X1000 barrels) but you can buy such a future for

  • as little as a $1000 and leverage the rest.

  • The price goes up to 25 dollars next month, and you sell the future for that price- $25K

  • ($25 price x 1K barrels).

  • You still owe your broker 19K dollars since you only paid 1K for this contract and you

  • are left with your thousand dollars and a 5K in profit.

  • You profited from crude oil without producing it or buying it..

  • So back in 2001 and 2002, many of these traders speculated that the price of crude oil would

  • rise since countries like China and India were growing exponentially.

  • They would need more oil to keep growing, so the demand for oil would increase.

  • Therefore oil prices kept growing until they reached 140 dollars right before 2008 and

  • crushed together with the rest of the economy as everyone expect the demand for oil would

  • fall since there is a financial crisis in the streets.

  • And since then, they haven't really grown that much since renewable energy is getting

  • more and more popular and a wide range of other factors.

  • But that doesn't mean oil is getting worthless.

  • At least in the next few decades, the oil will still be the major source of energy,

  • because it is not only used to fuel your car and plane but in almost everything we use

  • day to day.

  • If that's is the case, then how did we end up with negative oil prices $-40.

  • First of all, we had a price war between Russia and OPEC countries.

  • OPEC is an oil cartel that consists of 12 major oil producers, but Russia isn't part

  • of it.

  • However, in recent years, Russia decided that if it would better if it would collaborate

  • with OPEC.

  • But then in March Russia decided it won't need OPEC anymore and would better off on

  • their own.

  • So the de facto leader of OPEC Saudi Arabia decided to punish Russia for violating the

  • agreement by flooding the market with so much oil that prices dropped by half.

  • Traders and speculators were already afraid that oil prices would decrease further and

  • placed future contracts at a lower price.

  • And then the Pandemic struck the entire planet.

  • The United States and other major consumers of crude oil had to go on lockdown.

  • So with so much oil in the market and with no one to buy it, of course the price significantly

  • dropped.

  • Especially future contracts, since their price change daily based on what's happening in

  • the industry.

  • But what was interesting is what was happening with futures of WTI or West Texas Intermediate.

  • Their last day of trading crude oil futures contract was 21.04.2020. which means all the

  • oil traded under this contract is set to be physically delivered next month, which is

  • in May, but the country is on lockdown, and the demand for fuel is below the ground.

  • Since there aren't any cars in the streets and planes are grounded and parked at airports.

  • In other words, a ship full of oil will be delivered (to US), but there is nowhere to

  • store it because the United States has seen its oil storage capacity fill up.

  • After all, airlines and other buyers aren't using nearly as much crude oil as they were

  • before the crisis, so if the firms with the ability to store it aren't buying it.

  • Still, you have to do something with it.

  • You can't simply throw it away or ditch it in the ocean.

  • So the owners of these futures wanted to get rid of these contracts by selling them as

  • soon as possible because as mentioned before, they have nowhere to store that oil.

  • And since no one was willing to buy these contracts, the owners of these futures paid

  • the buyers who have the capacity to store that oil to take it off their hands so that

  • they can exist the market.

  • So what does that mean?

  • The oil isn't sold for free or at a negative price.

  • No one would spend millions of dollars to extract the oil and then end up selling it

  • for free but rather only the demand for futures (CONTRACTS) in the financial market dropped

  • so significantly that the owners of these futures had to pay the buyers to take off

  • the burden of storing the oil from their shoulders.

  • In fact, the negative price has scared off investors so much that the price recovered

  • the next day.

  • The futures for the next few months are already higher, reaching even 30 dollars per barrel.

  • Of course, futures and forwards are a bit more complicated than what we have explored

  • in this video, but in the middle of so much misinformation, I wanted to provide some clarity

  • on what exactly negative oil prices mean.

  • And I apologize that this video isn't on time, the problem with our videos is that, they

  • take a lot of research and are animated by a different person so the video can take sometime

  • before its ready to be uploaded.

  • In anyways if you enjoyed this video and found it in any way helpful, please give it a thumbs

  • up and let me know in the comments about what do you think about all of this.

  • And of course, if you are new around here, hit that subscribe button and the bell besides,

  • Thanks for watching and until next time.

A commodity (crude oil) that was once trading at 140 dollars suddenly became so worthless

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What Negative Oil Prices Really Mean

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    Summer posted on 2020/09/16
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