Understanding what’s going on with oil prices – the avocado theory
JOHANNESBURG – The year 2020 hasn’t been short of unprecedented occurrences and unexpected surprises. On 20 April for the first time ever, the price of West Texas Intermediate (WTI) crude oil, the benchmark price for US oil, fell into negative territory.
While oil has rallied since plummeting below zero in April, the spike in Covid-19 cases in several US states has raised fears of a further decline in the demand for oil – with experts saying prices are unlikely to return to three-digit levels ever again.
What precipitated April’s historic sharp fall? It was primarily because of a technicality of the global oil market and a lack of storage capacity. Don’t be put off by this explanation; there’s a simpler way to describe what happened using a locally grown favourite fruit: the avocado.
Avoiding rotting avocados
If you are an “avo-on-toast” regular, you may understand the avocado market very well. You know that prices can wildly fluctuate depending on the season – because they grow in winter, they’re usually cheaper at this time of year and prices tend to rise during summer when they’re out of season.
Let’s say to take advantage of the situation, you put in a bulk order in winter of 1 000 avocados for settlement in the summer. The avo seller is happy because he’s sold his avos in advance and you’re happy because you believe you could make a profit when you sell them on to the local grocer at a higher price in the summer (no, they’re not all for you!).
However, unbeknownst to you, one farmer had ramped up production and planted five times as many crops as usual so the market becomes flooded with avocados.
Then coronavirus arrives, countries all over the world go into lockdown and no one is going to the shops to buy avos so there’s a huge drop in demand. Your 1 000 avos coming to market represent a further sharp increase in supply for the local grocer; consequently he no longer wants to buy them from you. At the risk of having 1 000 avocados rotting in your house, you are willing to pay the grocer to take them off your hands.
The oil market’s gone (avocado) pear-shaped
That, in a nutshell, is what happened to the price of WTI in April. There was a contract for delivery of crude oil in May which was due to expire on April 21. Anyone who had bought such a contract was obliged to be ready to take physical delivery of the oil on that day and store it at substantial cost.
Oil traders, who trade such contracts, never want to take physical delivery of the underlying commodity (barrels of oil). They just want to make a profit on buying and selling the contracts at the right time. As in our avo analogy, you never actually wanted 1 000 avos for yourself – you wanted to sell them on to the grocer the whole time.
Like the market for avos, the oil market was already flooded because Saudi Arabia had ramped up production earlier in the year, and with countries in lockdown and transport routes closed, there was also a lack of demand. This combination not only put pressure on prices but also meant that storage capacity was starting to run low. Then suddenly these oil contracts were due to expire which meant a whole lot more supply coming to the market. With nowhere to store it, the owners of the contracts were so desperate to get rid of the contracts that they were willing to pay someone else to take the contracts or take physical delivery (much like you were willing to pay the grocer to take the avocados off your hands rather than leave them to rot in your house).
Negative prices not the norm
While negative prices are quite a rare event, you can see how they’re not impossible. While the WTI price has recovered since April, experts expect it to remain volatile for the next few months at least. And whether or not you’re a fan of avo’s, price fluctuations are an important factor to consider in forecasting any household budget expensing.
Ebeth van Heerden is Schroders head of intermediary – South Africa.