Episode 6: Crude prices drop below zero

This week, for the first time ever, crude prices went negative – surprising everyone in the markets and at the trading desks. Gabe and Rodney weigh out if corn prices could also dip below zero, how COVID-19 is only part of the story, and the differences between a long and a short squeeze.

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Rodney: My wife and I, we're big into music, and we go to Nashville a lot. We like going to the beach. We like being around people and doing people things, and we're already looking forward to that next vacation. Spokane, Washington. To get to Glacier National Park in Montana appears to be our next vacation. That's wildly different than what we would normally strive to go. I think that has a lot to do with just this easing back into real life, right? Vegas has been on our list of places to go. We've just never been. A plane ticket to Vegas in June from Chicago right now, $35 round trip. I can't even drive to St. Louis for $35. That being said, I'm still like, "Eh, I think I'll skip this one for now."

Gabe: Will they hand you a barrel of crude as part of that deal, too?

Rodney: Yeah. I wonder if it requires a crude purchase to get that for $35. It's $70 or you purchase a barrel of crude as well.

Gabe: I was talking with one of our analysts and he's been around even longer than you and I have. He's probably got a decade on us or so. Nobody's seen this before. He's like, "Man, I feel like the market's just broken." I'll be honest, when I saw the negative number, I was like, "I didn't know the exchange could handle a negative price for crude."

Rodney: First off, I'm surprised they could. I'm impressed that it could, yeah.

Gabe: That was a huge surprise. To some extent understanding the fundamentals like, hey, there's a bunch of overproduction given the significantly decreased demand. And there's probably some other stuff going on that we don't have insight to, but we'll get over time. But man, that's crazy, a negative value for a commodity. The thing I always used to talk about, and you know when we go do our models and things like that, we kind of put a rough floor on the price of corn. Like if we want to forecast prices and do some distributions and modeling, I think we use $1.80 or $2.00, but something well above zero and certainly not a negative price. And so that's sitting back and thinking about, what do we do here? Now, on the flip side, you can pile corn up, which is different than crude, right? You can't just make a pile of crude. And so the value may go down and get real low in certain situations, but it seems unlikely in most... It's difficult to imagine a scenario where we just don't have places to put corn anymore.

Rodney: Sure. It's funny, I had the same initial thought. So if crude can go below zero, can corn go below zero, because in my head it's never been a possibility. But what's crazy is as late as say, Monday morning, I didn't think it was a possibility for crude. So things change. But then I got thinking, all right, so crude went to negative values. I understand that and I think we should talk more about what actually happened there. So hogs were next in my mind, so with the shutdowns and in Minnesota on some processing plants. And I got to thinking like, can hogs go to less than zero? Which takes me back to the 90s, right? So I'm going back a ways now. This was before my trading days for sure. But essentially, I don't... Hog futures, I don't think went to zero. I'm sure they didn't, but I do remember months where guys were just giving away hogs for free.

Rodney: So essentially the price is zero even though it's not maybe zero on the board, and you had to pay for processing of that hog to turn it into bacon. What everybody wants is the bacon outside of that pork. So that really is a negative cash value for that bacon or for the pork, since you had to pay processing, which I think back at the time, I remember it being like 200 bucks or 250 bucks. So a pig that you got for free cost $250 that's a negative value. So I think it is realistic that it could potentially happen in corn. To your point, we can store it in a number of different ways. And I don't know, did you see the spreadsheet that the guy made yesterday about renting a Manhattan apartment to store oil?

Gabe: No, I did not.

Rodney: So I'll send it to you, but he calculated the cubic feet of a $3,000 a month apartment in New York, in Manhattan, and figured out he could carry 890 barrels of oil in it and was buying oil at negative $35 and selling the carry for next May at positive $40 or something. So he was taking $75 a barrel, calculated interest, $3,000 payment. He forgot about freight, just like everybody always dose from Texas to New York.

Gabe: Walking up to the five story walk up in Brooklyn, probably.

Rodney: Yeah, yeah. Some logistical issues for sure. But he was net ahead like $36,000 paying $3,000 a month rent for a 500 square foot apartment. And that's a real thing, right? That worked.

Gabe: Yeah. Well, if you're going to go buy crude, if so, go buy 40,000 barrels, right?

Rodney: Yeah.

Gabe: At least a couple of buckets.

Rodney: I don't think it, 890, yeah. There's ETFs for that, right? I can get an ETF.

Gabe: Yeah, sure. Yeah, it does weird things, and that's why it feels like there's probably some other forces at work beyond just the fundamental evaluation, but that pushed it there, obviously, where it was possible.

Rodney: So this morning I got up a little early and was looking into this whole oil thing to see... And essentially the first thing I found was a news article saying, "Oil is at negative values. The world is clearly over because of COVID-19." So first off, Gabe, are you shocked to hear that reaction?

Gabe: I'm not. I'm not blown away that somehow it got connected back to that directly and that the world is ending, no.

Rodney: Yeah. And I'm always fearful that guys like me and you are the less sympathetic to that, overly non-excitable about that. Look, I think people get too excited and it's a great way to get people to listen to your podcast is to say the world's ending because oil is minus $40. I think we're the antithesis of that, but I worry about that we're overlooking some real connection there, but I don't think we are.

Gabe: So there are real connections, right? Again, demand for oil was down because demand for fuel and goods produced with energy is down. There's no question that we're in some degree of economic slowdown and the question is just, we won't really know until we're moving through it, how bad it is. And then, but the idea that that's the end of the world, that hyperbolic right headline is uninteresting. When you come at me with something like that... Not you, but when somebody writes a hyperbolic headline, it's kind of like, to be honest, these days most of the time I'll just leave it alone because you're starting out at this ridiculous place. And let's pretend you're right, the world's ending. The next thing I'm going to do is not read your article and go do something else. So I understand why they do it, but it doesn't feel helpful in terms of understanding. And of course, now we're all experts on negative crude prices.

Rodney: Yeah, yeah, me included. For sure. So now that we're experts, let's talk about what actually happened here. This appears to me to be a long squeeze.

Gabe: Well, we've seen it basically in any material bear move in equities, where people are long on margin and things start to turn, those losses are exponential. And so then they build on themselves, right? You see, sell, sell, sell, sell, sell. That's why those moves can be so violent because basically it's a long squeeze. Let's talk about what that is.

Rodney: Yep.

Gabe: So a long squeeze is when there's a participant in the market who owns a bunch of something. Generally, they own it and not only they own it, they actually probably own way more than they need, and it may be that they're just a speculator. In fact, they don't need to own any of it. And often they're trading on margin, which is they have much more exposure to the value of whatever it is they're buying, so in this case, crude, than the actual money they have. So the crude oil contract, when we're $20 a barrel and that futures contract is worth $80,000. One of the great things about futures is I don't have to give the exchange $80,000 to own that contract. But what that means is, I may only need $5,000 to own one contract. And so if I've got $80,000 I can go buy... let me do that math in my head... 20 contracts? No, 40 contracts.

Rodney: 40, yeah.

Gabe: You do the math. I'm just here talking about people. So I go and buy 40 contracts, which is... And so, going back to our math, so if I own 40 contracts, I actually own 320,000, 3.2 million barrels?

Rodney: 3.2 million, yep.

Gabe: Barrels of crude. And so every time the market drops, that's eating into it. So I own way more crude than I have any need for. And if it goes against me, I have to give them money to make good. So there hits a point where not only it's so bad that I basically lose control of the position because I don't have the money to make good. And then we see that's where the squeeze comes in. And so not only are you getting, if you're the owner, are you experiencing the loss from the basic move that happens, there's often a follow on negative move that comes from you having to exit, again in these long squeeze situations.

Gabe: Exit was generally a very large position in a very short amount of time. So I have to sell out of a bunch of crude, which pushes the market even lower, which then might trigger other knock effects. So I think that's the long squeeze you're talking about. It doesn't just refer to the amount of time it takes to explain, but when you're long, that means you own the market. So farmers are always long corn or whatever it is their crops are.

Rodney: Yeah. So I think what gets bypassed in every, or not every, but most articles that I've read about this so far is that it's that today is the contract expiration of those May futures. So if you were a speculator in the market, which we at some point we should cover speculators and how much we love them, even though a lot of people hate them. I guarantee a lot of people hate them after yesterday, some people. Where was I? Yeah, so expiration happened today. So probably historically there's only a few people that can actually take delivery on an oil contract. All right? I think we could probably name a few them off the top of our heads, right? I assume BP is one of those players.

Gabe: Exxon Mobile.

Rodney: Yeah, exactly. So what happened is, those guys are covering up in oil and they literally had no interest, space, anything for these contracts. So some other probably opportunistic person came in there and said, "Yeah, I'll buy that oil from you at negative whatever," right?

Gabe: You can pay me to buy from you, yeah.

Rodney: Yeah, right. So it got me thinking about a short squeeze, which we see more often. This morning I had this a-ha moment where I said long squeeze. That was the first time that that had ever gotten in my head, but short squeeze, I'm very used to. Why don't you talk to us about that just a touch?

Gabe: Most of the time if you're getting long on a market, so if you're getting long on something real, like you're buying equities or you're buying bonds, you may be able to buy on margin, but the ratios, so the number of things you can buy per dollar is a lot lower than many other things. So where it gets tricky is if I sell equities. You're never actually allowed to sell an equity that you don't own. How much money do I need to have to sell something I don't have? The answer is, not a lot, right?

Rodney: Right.

Gabe: So all short equity sale, or almost all of them, trade on margin and obviously, all futures contracts trade on margin, which is the crude situation, but also if you're selling equities, you're always trading on margin. And so that's why we see it more often in more markets because if you short things in cash markets... Now, futures markets, you do those on margin basically. And so it's easy to get in trouble by taking on a lot more exposure than you should be, and so that's why I see it more often.

Gabe: So a similar situation where I've sold a bunch of things, maybe I think Google's going under and I go sell a million shares of Google, and then all of a sudden Google starts to go up, well, I've got to pay somebody that difference, right? And so it's the same story except going the other way. So now I have to buy back those shares of Google that I sold and I probably have to buy back a lot in a short amount of time, which causes further price increases that may also trigger additional buying or it may cause other people who have shorted the stock to also have to get out. Right?

Rodney: Yep.

Gabe: So there can be these chain reactions anytime there's somebody getting squeezed. And ultimately, these things are generally exacerbated because it's a bunch of volume trading that isn't really expected and it's trading in a small window of time and doesn't have the luxury of taking it easy.

Rodney: Yep. Yeah, and we've seen since electronics came around in the commodities business, we've seen a few short squeezes that were really quick, right? I can't remember the dates. I swore I would remember him forever where somebody accidentally bought a million contracts of something and the market was happy to squeeze them out on the way up or whatever, right?

Gabe: Yeah, the whiplash.

Rodney: Even though they had no business being in there. Yeah.

Gabe: Yeah.

Rodney: And in seconds we saw that.

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