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FAQ: the Volatility of Oil

April 21, 2020 by Miranda Carr

Given the recent extreme volatility of oil prices, we’ve put together a FAQ list to help you stay informed.

How does oil trade?
Crude oil trades in futures contracts, which means buyers are contracting to buy oil in-kind and accept delivery. There is typically volatility around contract expiration, but it is more pronounced in this environment. When trading futures, there’s what’s known as the “front-month” contract which refers to the nearest expiration date for a futures contract. The current front month contract is for May, which expires today (4/21). Buyers will begin taking delivery next week (May 1), and the June contract will be the new front month contract trading tomorrow (4/22). You’ll notice the June contract is trading at a significantly higher price than May (approximately $15/barrel for June versus $1 for May).

Why is oil trading at negative prices?
Due to COVID-19, people and businesses are not using as much oil for everyday activities as we were just a couple months ago. In fact, gasoline demand was down about 50% from the prior year at the end of March. Due to less demand, buyers are now out of storage for oil which the low/negative prices reflect. Furthermore, those who currently own contracts do not wish to take delivery. They most likely have no capacity to take delivery, so they are effectively paying buyers to take it off their hands. The oil market typically trades in contango, which means the front month price is lower than prices in the future. This partially reflects the cost of storage.

How can I take advantage of negative oil pricing?
Investors do not have a good way to directly take advantage of the significantly discounted oil prices. The ETF that provides exposure to oil is fraught with structural problems and is not on our list of recommended holdings. Only those who can store oil can buy at the deeply discounted prices seen and take advantage of the pricing.

Investors can invest in asset classes that have exposure to oil. Midstream funds (MLPs) provide exposure to oil and natural gas. Some fixed income funds have exposure to companies who will benefit from a rebound in oil prices long-term. Finally, many equity funds hold energy company stocks, which will benefit when demand picks up.

If you’d like to discuss your investments, please reach out to your Relationship Manager or click here to request an appointment.

 

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