Question

1. Review   and discuss the collapse of the Futures Oil Market, which   fell into the negative realm in May 2020.

What were the main reasons for this fall into the negative realm? Critically discuss.

2. After May 2020, what are the prospects of futures contracts as a significant risk management tool for firms? Discuss critically.

Answer 1

Why oil price went negative, in 3 levels of detail

Level 1: The coronavirus pandemic has erased as much as 30% of global oil demand and producers have yet to cut even a fraction of supply.

• The world is now awash with oil that nobody wants, causing storage to fill up.
• People who owned contracts for oil were paying buyers to take their oil, sending the price into negative double-digits.

Level 2: Oil plunged into negative double-digits in part because of a market technicality.

• Usually, when people refer to the price of oil they're talking about futures contracts meaning, the price of oil that will be delivered at a later date.
• The price went negative was for futures contracts to be delivered in May.

Level 3: The oil price that went negative for two days was West Texas Intermediate or WTI.

• WTI is the benchmark for US crude oil, making it the most important futures contract to watch in the US.
• Globally, Brent crude is the benchmark, and while it's fallen by about 70% since the start of the year it's still far from negative.
• A big difference between the two benchmarks is proximity to markets. WTI oil is delivered to crushing, Oklahoma- a city that is very much landlocked, unlike Brent.

Futures contracts are complex derivative instruments to manage risk in the global financial market that derive their value from underlying assets . Greenspan honored their development as “the most significant event in finance during the past decade“, while Buffett warned only a few years later against derivatives by calling them „financial weapons of mass destruction“ and prophetically linking them to the global financial crisis.

While derivatives compromise a range of financial instruments, futures contracts are an agreement between two parties to buy or sell an asset at a certain time, a certain place, for a certain price and amount in the future. These underlying assets can vary from a wide range of assets like live animals or products, commodities, bonds, currency, stocks, or the weather.