This is a Transcript of The JeffEffect podcast from April 24th, 2020.
Is Oil Selling for Negative Money?
[intro]
[0:10] All right, guys. It is time for us to talk once again. This is Jeff. And there has been so much misunderstanding, disinformation, breathless headlines in news shaking the world this week that it's making my freaking head explode.
It seems that oil is now selling for negative money.
How is that even possible? Here's the deal. It's not possible, but let’s take a little hint here. Let’s listen to some news. Let’s listen to some of the talking head media folks out there. I'm just picking a few at random. Here is media industry stalwart, trusted news source Reuters and what they said.
[recording from Reuters news]
“Right now, a barrel of US oil is worth less than nothing. This week saw the country's benchmark crude price plunge below zero dollars for the first time in history.”
And now, although they are not known for their intellectual quality or their accuracy, here's a story from Al Jazeera.
[recording from Al Jazeera news]
“Why did US oil prices hit negative territory? An unprecedented fall in American crude oil sales has added to the hardships caused by Coronavirus. So, what will that mean for the US and the global economy? This is Inside Story.”
Here's one more. Now, Jim Cramer gives a lot of investment advice on CNBC and he's a bright guy and he understands the investment markets, but he says this terribly. He communicates exactly the wrong thing.
[recording of Jim Cramer]
“At the top, I talked about the craziness of the oil patch and we watch as the price of West Texas Intermediate crude for May delivery, went from the high teens to less than zero just in one session. The refiners don't want it. There's no storage space left, so sellers are literally paying buyers to take this stuff off their hands. Do you know once the panic spread, oil prices went to absurdity levels. It closed at -$37.63. You probably think that couldn't happen ….”
Okay, so if you listen to all of those, you would think that you could go right now to an oil well, you could drive to Texas, find yourself an oil well, walk up with the barrel, and have them fill it for you, and you would walk away with a bunch of money in your pocket. They would pay you to take the oil.
[recording] Welcome to Oil-Mageddon
The Idea of Selling at a Negative Price is Ridiculous
I can totally see this is true because I just filled up my gas tank the other day. I drove up, I put my credit card in, and I pumped my gas, and I put in 15 gallons, and it credited my bank account 6 bucks. That’s not how it works. Let me guarantee you this is what has not happened. Not one barrel of oil has changed hands for negative money. In fact, as the futures price of oil was falling into negative territory, the actual price of oil on the market — the price at which it was being bought and sold on the open market — was between 14 and 17 dollars at the exact same time that everyone was quoting that the price of oil had been negative, as much as $37 in a single day, on April 20th.
What Are We Really Measuring?
[3:57] What does this all mean? Well, the problem is what we're measuring; it's what we're looking at. When we try to follow these things, we need numbers that we can actually use, as investors and as consumers and as economists. We rely on a certain set of things that are quoted to us. One of the things we rely on, all of us do, is we rely on the Dow Jones industrial average. That's really a basket of 30 stocks, just 30. We use it kind of as a proxy and that means we use it as a measurement. When the Dow was going up, you feel good about the world. When Dow was going down, we feel less gold about the world and maybe our 401ks aren’t as punchy and lively and exciting as we want them to be. There are other ones, too. There's the S&P 500. That's 500 stocks. That's the 500 largest corporations rated in the United States. We have the Russell 2000, which is 2000 of smaller company stocks. The point being is these are all benchmarks. There's something real there. There's something we can see that we look at and we can say, “Okay, well the stock market's moving some places and there's real stocks underneath there somewhere that are being bought and sold for an amount of money that is reflected in these index prices.”
[5:18] Whether you're using Yahoo! Finance, or Bloomberg Terminals, or whatever you're using, Market Watch, whatever you're using to follow the price of commodities, they're not really talking about the price of anything. They're talking about the anticipation of a futures contract. Let me talk to you about what happens. People get really confused on this, and it's a really important lesson that will help you your entire life so you don't get sucked into this.
None of Us Normal People Should Buy or Sell Futures Contracts
I got to give a caveat. No individual consumer on the planet should buy and sell futures contracts, either buy-side or sell-side. Nobody should. Why? Because it's wildly speculative. Let me talk about a futures contract and what it really should do — what it's good for — because it's really good for something. A futures contract is actually about eliminating risk. It's not about taking a risky speculative investment. Best used, futures contracts are about eliminating risk. Let me explain that to you.
How “Real” Futures Contracts Work to Reduce Risk
I like to talk about whiskey a lot. Let's talk about Jack Daniels. You’re Jack Daniels. You use a lot of freaking corn. Corn is the number one ingredient in your whiskey, the number one. You need it. You need corn every single month and importantly, you need to make sure that you have corn this month and next month and June and July. You need corn in August and September and October and November. You need corn every single month, but you also need predictability. You need to be able to ensure that you buy corn at a price so you can set the price of your whiskey because it's the number one input, the number one cost by volume of things that you have in there. You need to make sure that you have a predictable price otherwise you can't tell your distributor, “Hey, when Christmas comes in December, I'm going to be selling you my bourbon whiskey at $40 a bottle or $20 a bottle. I can't tell you that because I don't know what it's going to cost me.” If you, however, are allowed to secure a contract to pre-purchase your corn in advance of you needing it, that gives you predictability. It takes the mystery away and it allows you to set your prices and run your company.
[7:48] Likewise, if you're a farmer, if you're planting your corn, you don't want to be subjected to the ebbs and flows and swings of a commodity price. You want to be able to plant your corn and grow it and harvest it and know how much you're going to get for it. This is a perfect scenario for two people to have a futures contract. The farmer’s growing corn. When you start planting season, you don't know how good the season is going to be, but you kind of guess about what your production level is going to be. Jack Daniels needs to buy corn and both of you guys need …. You need to sell corn in July, Jack Daniels needs to buy corn in July, so you can do a futures contract. Jack Daniels can give you a 20% deposit and say, "Hey, here's the deal. I need 10,000 bushels of your corn or 100,000 bushels of your corn and I'm going to pay you a set price for it. You grow it, and then when you deliver it, I’ll give you the balance of the money.” Farmer gets a guaranteed price. He knows how much money he’s going to make before he plants his first seed. Jack Daniels gets a locked-in price. He knows how much he has to charge for his whiskey the following year when he starts selling the distilled product. Both parties to this transaction have eliminated or substantially reduced their risk of them doing business. This is a good thing. Futures contracts in this way are a good thing, but here's what happens. You have a lot of speculators out there who are betting. You have a lot of people who don't use corn speculating on the price of corn.
[9:30] Let me give you another example, and it's kind of tough now because the airline industry’s in big trouble because of the whole COVID thing, but let's use the airlines as an example. One of their biggest — in economics we call these inputs — one of their biggest things they need is jet fuel. It makes sense, right? You get one of those big 737s in the air. It burns a thousand gallons of fuel an hour or something like that. Whatever it burns, it burns a lot of jet fuel. That's one of their biggest flow inputs … but they need to sell tickets. If you're planning your family vacation to Orlando to see Mickey Mouse at Disneyland, you are going to want to take and buy your tickets as far in advance as possible because you get a good rate. But, if you're the airline, how do you know how much to charge for the ticket?
You got supply and demand issues, the seasonality issues that could tell you how many passengers you’re going to have, and all those things help you. They help you take and set your price but your biggest flow input is jet fuel, and if you don't know how much jet fuel is going to cost six months from now, how can you price a ticket six months in advance? You can't. What do the airlines do? The airlines put a contract, and they buy their jet fuel months and months in advance. The companies that make jet fuel — they're perfectly cool with that. They get a guaranteed sale and transaction. They know how much to produce and in return they know how much they need. They know how much jet fuel they need to make. It helps them set their staffing levels; it helps them set up a new storage tank if they need to; it gives them predictability. What do they need? They need barrels of oil because jet fuel is made from oil. They buy a futures contract on oil so they know how much oil it's going to cost them. When it arrives, they know how much they're going to pay. That means the jet fuel refiners can set a price. They can manage their industrial operation, and they can take and set a firm price and guarantee a price to American Airlines or Delta and give them a firm price. Delta can then sell you an airline ticket six months from now. Otherwise, they couldn't do it. It'd be a crap-shoot.
[11:59] This is another example of how a futures contract — in this case, two futures contracts — remove risk from the transaction. It allows the economy to function soundly. Do you understand? These are good things, but what you have is these futures contracts are purchased. They’re bought and sold on the open market and in the case of oil, you've got people buying oil contracts because they're betting.
The Speculators
They buy a futures contract and say they buy it at 20 bucks a barrel, which is what it was a few weeks ago. They say, “I think it's going to go up.” This is exactly what happened in our situation here. They purchased for May 20 delivery a futures contract that closes on April 20. So, in other words, you can't trade the contract more than a month in advance. They know that their plan was to buy a futures contract for delivery of oil on May 20th and then they're going to sell it before they took delivery because these guys don't want oil. They don't want to have oil delivered to them. They don't want corn delivered to them. They just want to control the contract because they believe the price is going to go up of that delivery. And most of the time, they're pretty good at their job.
Most of the time, these guys are guys who are supposed to be masters of the universe; they're supposed to be freaking experts in these things and they study the charts and stuff like that. They rightly said they were looking at the price of oil on the global market and it was, wow, it was pretty low. It was lower than it's ever been, so they said, "You know what? I bet this is going to go up between now and April 20th when this contract closes. I'm going to buy my contracts and then sell them at a profit.” You can do that. You can buy your 100,000 barrels of oil or 10,000 barrels of oil or whatever the size of the contract that you do, and then you can take and wait. Then you sell that contract before it closes to somebody else who really needs the oil. You see how that works?
The People Who Really Got Hurt by the Crashing Oil Futures Contracts
But, you had a lot of people out there just stuck with this contract. What had happened is this. People who were trading that contract before the price of oil kept going down, dipped below $20 a barrel, kind of bounced back up. Everybody thought they were okay, and everybody was hoping and praying that the real price of oil was going to stabilize and go up a little bit. It will go up a little bit, just not today and not in time for them. What happened is you had all these speculators trying to sell their contract to buy oil at the same time. This is maybe kind of hard to understand because no actual oil was changing hands …. These were contracts for a May 20th delivery, so none of this oil has been delivered yet, none of it. Zero of the oil has been delivered, but I guarantee you when it is delivered, it will be delivered for a market price — a spot price.
[15:21] You have a bunch of guys sitting in New York financial towers downtown and going back home to their house in the Hamptons on Long Island and trading at night and buying these on speculation. You have a bunch of guys who manage derivatives, a bunch of guys who manage hedge funds, and these people were all in a very bad situation because they owned contracts for oil delivery and they had to make good on those contracts by April 20th because the contract period was closing. If they don't sell their contracts, figuratively speaking, a truck's going to pull up outside their building filled with oil and say, "Hey buddy, where do you want me to put it?” They don't have any place to put it. They don't want the oil. They don't want it at all. What they wanted was profit on a transaction when they never actually touched the oil. But, as sometimes happens, they got caught in a pinch. The contracts were closing and everybody had to sell it at once.
When people on the news are talking about ‘their hair is on fire and they're running around’, they're leaning in and they say to you, “oil is selling for negative money.” That's not true. It gives the false impression. It gives a wrong impression. Those oil barrels haven't even been delivered yet, and they won't be delivered for four weeks.
What has happened is those guys had to get out of their contract and they bet wrong and so now they're stuck paying somebody to take the oil off their hands that they don't want. This is what’s really interesting and this will prove it to you. You can just believe me. You can double-check me. Do whatever you want, but here's a way to kind of measure that.
Hedge Fund & Derivative Guys Got Crushed
On April 20th, as … the May 20th futures contract for oil delivery, as it was crashing below zero, as it was selling minus $37 per barrel, oil stocks were off like 3% or 4%. Chevron was off a couple of fractions. Exxon was off just a little bit. All these oil companies … they’re the ones who bring the oil out of the ground. If they were the ones having to pay people to take their oil, their stock would have been crushed. But the truth is their stock wasn't crushed because that's not what was happening. A bunch of financial guys who bet wrong were getting crushed. I feel for them. This is career-ending stuff. If it's your job … to buy and sell futures contracts to make a little bit of money for your Wall Street firm, you just cost your company millions or maybe even billions of dollars. But those millions and billions of dollars were lost on Wall Street. They weren't lost in the oil fields of Texas or out on the decks of oil platforms in the Gulf of Mexico. The money was not lost there; all of this money was lost in Wall Street.
[18:42] I don't feel good about that. Maybe you celebrate that. Some people would celebrate that, but the point being is the net impact on the economy will be zero because oil is not selling negative. Oil is selling for a price that's low. It's way too low and it will correct itself and get back in a reasonable range if the people cut production. In reality, at the exact same moment that the oil futures contracts were selling at huge negative numbers, they were selling for low positive numbers in the real world.
Does that make sense? I hope it makes sense, because everybody’s … hair’s on fire. How could this have a negative impact on the economy? You have all those finance guys. They just lost millions or billions of dollars in the financial markets trading futures. To cover their losses, they might need to sell other assets just to get themselves whole again. The last thing the stock market needs right now is people selling more stocks or selling more bonds into a market that's already got some challenges. But, you know what? It's been a couple of days now and the stock market is largely stable, so I just don't think that's the case.
All the Flashy Headlines Are Meaningless
Once again, all the flashy headlines, all the crazy alerts and dramatic music on the newscast with instant updates stock market trading negative, all that was meaningless and will likely have zero impact on any of our daily lives.
If that doesn't make sense, just DM me on Twitter. Right now, it's still the best way to get a hold of me. News is coming so hard and fast right now. It's a blaze trying to keep up on it, but I hope I've brought some clarity in some concise statements and understanding to this seemingly crazy, mixed up world.
DM me — that's @JeffreyJHardy on Twitter, or you use the contact form on JeffEffect.com, which is the website of this podcast.
Remember folks, it's going to be fine. We’re going to get through this. Capitalism isn’t dead. We're going to be fine once we get the economy re-opened again, and that's the key, as quick as possible. It makes a difference. I love you all. I hope you’re doing well. Let me know if you need any help with anything. Talk to you soon. Bye for now.
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