When we buy stocks – as long as we don’t trade on margin – we know that the worst case scenario is a 100% loss on our investment. But that turns out not to be the case with the oil market, which entered record territory last month.
On April 20th, the price of West Texas Intermediate (WTI) for May delivery opened at $17.73 a barrel, and then started a long slide.
The contract was set to expire the next day, and most traders don’t want to take delivery of 1,000 barrels of oil. Given the COVID-19 induced demand collapse, it wasn’t surprising to see selling pressure the day before the May contract closed.
As oil prices fell, one person after another called or messaged me to ask if I thought it was a good idea to jump into this market. I repeatedly warned people that there are just too many uncertain variables in the oil market right now. When the contract reached $10/bbl, one person said to me “This has to be close to the bottom. How much further could it fall?”
Others were asking me about the implications of actually buying the oil and taking delivery so they could sell it later at a higher price. But that’s complicated. Physical delivery is in Cushing, Oklahoma. You have to arrange for transport and storage. Right now, many people are storing oil, so it’s costly to do it. Don’t get me wrong, there are traders who do this — but it’s not a strategy for casual traders. It’s certainly not one for traders who wanted to cobble together a plan the day before the contract expired.
Then WTI did something it’s never done before. It broke into negative territory. At that point the price went into free fall. The May contract for WTI traded as low as -$40.32/bbl, before closing at -$37.63/bbl.
Imagine that early in the day you saw that the May WTI contract was trading down more than 70% at $10/bbl, and you thought “I have to get some of that. How low can it go?”
It turns out it could go a lot lower than anyone imagined. If you spent $10,000 trying to bottom fish when oil was $10/bbl, before the market closed you saw that $10,000 investment turn into -$37,630 of oil.
I saw the CEO of CME Group — where these contracts trade — explain this the next day on CNBC. As he explained, the potential losses in trading oil contracts are limitless. Invest a dollar and possibly lose ten. Unlikely, but not impossible.
The new front month contract is for June delivery. Given the current demand trends, we may see a return to negative prices when this contract approaches termination later this month.
The physical oil market has always been risky for speculators. We now know that the downside risk can extend well beyond your initial investment.
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