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What’s Happening to Oil Prices?

Another week, another head scratcher. News of the price of oil going negative has sparked questions about what negative trading means for investors and consumers. Jared Kizer explains what we need to know.

Transcript

Tim Maurer:
Hello, Tim Maurer back with another episode of Ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Jared Kizer, Chief Investment Officer of Buckingham Wealth Partners. And Jared, throughout the COVID-19 crisis, the stock market volatility may be getting more of the headlines, but the price of oil has been even crazier, even trading below zero recently. Could you please explain what’s happening in the oil markets?

Jared Kizer:
Yeah, it certainly attracted a lot of attention and I think it’s one of those things that you can write down on the long list of things you probably never imagined you would see or read. The negative prices in oil, we’d seen negative yields on fixed income outside the U.S. for folks that had been tracking that, but negative prices on a commodity I’m sure is something that we probably never thought we would see. So there is something meaty there to talk about but I want to first basically give a little bit more context to the energy markets. And one of the things that’s tricky, particularly about oil, is there is no one price. You think of what’s the price of Microsoft stock? There’s a single price for Microsoft stock. With oil, it gets a little bit more complicated because there are multiple prices.

Jared Kizer:
There’s what we call the spot price of oil, which is what you could buy physical oil for. And then it gets gradually more complicated as you go into what is known as the futures market, which is what was being referenced when oil prices went negative. So that’s something that’s important to understand but nevertheless confusing that there is no one price for oil. But what we did see in terms of the price going negative was related to basically delivery of oil in May in the U.S., something hyper, hyper specific. And the dynamics that were going on again that you would have never imagined is that there’s been so much storage of oil, physical storage of oil, that capacity for storage is limited. So anybody that was going to be forced to take delivery of physical oil in the U.S. was basically being required to do that because they knew storage is really expensive, there’s not a lot of storage to begin with because it’s mostly a filled up.

Jared Kizer:
So you basically had this weird, almost a technical glitch if you want to think about it that way, of basically people being required, requiring others, to be paid to store oil and therefore that the price went negative. But if you looked a little bit further out and said, “Okay, what does the market think oil is going to be worth six months from now or 12 months from now?” Those prices are still positive. They’re obviously much lower than they were to start the year with everything that we’ve seen going on with the pandemic and its impact on the broader economy, but that gives a little bit of comfort. We’re not talking about prices are literally negative across the board. It was really super, super focused on essentially delivery of oil in May in the U.S. and the dynamics surrounding that.

Tim Maurer:
Fascinating. Now one of the things I’d love you to do is talk a little bit about futures and perhaps derivatives just in general because oil gives us a great example of where there’s an actual physical, tangible product, that you could literally have a barrel shipped to your house and put it in the garage. But at the same time, the way that it becomes tradable is through derivatives. Talk a little bit about derivatives and how they are formed and what it looks like in the case of oil.

Jared Kizer:
Yep, super important point, Tim, and it’s kind of an extension of the conversation that we’ve been having up to now. So when you think about investing, when you hear oil reported almost anywhere in terms of prices, it’s almost always the futures, what’s called the “futures price of oil”, which is a derivative. That’s essentially the way the financial market side of oil operates. So it is a little bit tricky to explain, but essentially a futures contract, the word futures has a meaning because it’s essentially about two parties agreeing to a delivery price for oil, physical oil, at some point in the future, so you might have a July 2020 energy futures contract where there’s a buyer, there’s a seller, and they’ve agreed, okay, in July we’re going to agree to transact in $30 per barrel price of oil.

Jared Kizer:
They agree upon that price today and then what it becomes about is, okay, when that day eventually gets here, is the price higher or lower than the $30 that we agreed on? And that determines who “won or lost” in that particular trade. So there are a lot of moving parts there but essentially I think the simplest way to think about this particular type of contract is it’s about two people agreeing on a price of a commodity into to the future. That’s why it’s called a futures contract. And what will determine who won or lost on that particular trade will be, again, whether oil is worth more or less than what they agreed on when they originally entered the contract.

Jared Kizer:
And again where this all relates to what we saw with the negative prices is this particular contract that that was referenced in the reporting this week does require physical delivery of oil. Meaning you can’t settle the trade in cash. If you hold that contract to expiration, you will literally have oil delivered to you in Oklahoma and that creates all kinds of dynamics related to if they were able to just settle the trade by exchanging money. Essentially, that’s not the way expiration of this particular contract works.

Tim Maurer:
I’ve got to think there’s some funny examples of this happening for people who end up thinking, “Hey, I need to get into oil right now,” and all of a sudden they’re surprised. A buddy of mine texted me the other day and he said, “Tim, I just wanted to thank you for being such a great friend. I bought you a barrel of oil.” And I said, “I don’t know where to put it.” But beyond the humor, does this actually create an opportunity for investors? Could I actually buy oil at an extremely low price through some sort of derivative that I could then benefit from in the future?

Jared Kizer:
Well, you certainly are going to be able to buy it at a lower price today than where it started the year. That that part is absolutely true. No matter how you would, there are multiple ways to go about investing in oil if somebody were to do that. There’s no doubt, yes, it’s at a price much lower than it was when it started the year. So we’ve gotten that question, understandably. The way that I think about this is the real answer to your question in terms of, is this a good opportunity, is basically very, very similar to do we expect stocks to be higher a year from now than they are right now? My guess would be that if the answer to that ends up being yes, then oil prices will also be higher. So I think of those as almost tied at the hip at this point. They’re not perfectly related to each other, but I would say if you own stocks or you’re rebalancing back into stocks, you’re essentially doing something similar to buy oil.

Jared Kizer:
So I don’t think you need to do that necessarily in addition to what you’re doing on the stock allocation, because if you think about it for a couple of minutes, it becomes pretty clear that, well, if the stock market recovers, it’s probably also going to mean oil prices have recovered. So if you own stocks, you’re kind of exposed to that result already, is one way that I would think about it for folks that have those questions. I would say in general, no, there’s not anything specific to oil that we would recommend doing because if you own stocks you’re kind of already in the mix on that front to begin with.

Tim Maurer:
Right. That makes sense. That makes life a little bit simpler too, life and investing. But what does this mean for us beyond as investors? You’ve helped us better understand that. What does it mean for us as consumers? I mean, obviously, if we were driving you’d see lower gas prices today, but most of us aren’t driving. What about the price of say heating oil for example when temperatures turn colder again? Any there any other ways that we can benefit from these low prices as consumers?

Jared Kizer:
Yeah, it’s a challenging one. I know Larry Sweatero from our investment policy team always likes to say, “The silver lining of when energy prices crash or go down as they have, is it’s effectively like a tax cut to the global economy.” So that’s usually the silver lining. Obviously, we’re in an entirely different world right now because unfortunately there’s very limited ability for consumers, for travelers, for anybody to actually take advantage of that while we’re mostly kind of sheltering at home or traveling very small distances and not driving. So it’s one of those things I think, unfortunately, if you do happen to be in a job where you are still having to travel a lot by car or whatever the case would be, certainly you’re benefiting from that. But I think the circumstances that we’re talking about now, which are basically get sheltering in place kind of dynamics still at this point in time, means there’s really not much from a consumer perspective or from a spending perspective in terms of a huge potential benefit there.

Jared Kizer:
Because, again, most of us have no ability to go out and say, “Oh I’m going to store gallons and gallons and gallons of gasoline or oil.” Sp practically there’s not, from a consumer perspective, a lot of way that most people are going to benefit. Now, if we take your question a little bit further down the road we get into winter or whatever the case would be, I think if you look at the forecast which have wide ranges of air around them in terms of what this recovery is going to look like I think most people would still say they would expect energy prices of all shapes and forms to be lowered still then, if you talk about even later this year, maybe even early next year, than they were to start 2020.

Jared Kizer:
So I would expect as we do start to see hopefully some gradual loosening of the shelter in place without a lot of health repercussions hopefully that you will see people generally start to be able to benefit because prices will likely still be low, maybe not at as low as they are today, but probably still low because I don’t think much of anybody is forecasting for the broader economy, for the global economy like we’re going to be literally back to exactly where we were by winter. It seems pretty unlikely at this point, which means probably energy prices will still be quite a bit lower than they were to start 2020.

Tim Maurer:
Well, Jared, thank you so much. Normally, when people say it’s an entirely different world out there they’re being hyperbolic, but this might be the first time in at least in my lifetime where we can say that, and it’s 110% true. Really appreciate your help, and thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com, or by emailing your question to question@askbuckingham.com, or just clicking the screen and it’ll take you directly to the website. Remember, there are no dumb questions, but unfortunately there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, it will bring a sense of calm, allow you to apply what you’ve learned in pursuit of good decision making. So please follow us, and by all means, Ask Buckingham.

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