Oil traded to negative $40 earlier this week. Few people realistically thought this was possible, and in the days after the historic April 20, 2020 crash, market-watchers were left wondering, ‘how can this happen’? I wrote up this note to a client who posed the question.

Storage is literally full. They have to pay people to take delivery & store it. Oil futures are ‘physically-settled’, not ‘cash-settled’. So if you own the oil futures contract on expiration day, you have to take the oil. Which means you have to pay to contain it and then store it. In the past when storage on land neared capacity, oil tanker ships would fill up with oil, but now those are full too. What’s really weird though? Oil drilling stocks are up 4% this week (the ticker is XOP)! Just goes to show that the market can fool logic a lot of the time. Nothing is impossible in financial markets.

So that explains why oil can trade below zero dollars. But maybe just as shocking is the very companies you would expect to be hammered by negative oil prices were the stocks investors were buying as oil plummeted. Why? Because financial markets are almost designed to fool people. If they were completely rational, there would be no risk premium for long-term investors.

How does this apply to hedging & risk management? Everything. Nothing is impossible. Market participants must always keep that front & center in their mind. While past data is important, always be aware that something new will happen in the future. Everything is unprecedented. It’s always different this time. Risk managers must always be forward-looking. 

Chart via Tradingview.com