Question

Using the commodity futures pricing equation, show how an increase in storage cost gives rise to a negative futures price but from the formula an increase in storage cost increases the futures price. ( This is in relation to the negative prices observed in the futures market for oil recently )

Answer 1

Futures price = (Spot price + Storage cost) * e^(rt)

From the formula, if the Storage cost increases, the futures price increases.

But, in recently increase in storage cost gave rise to a negative futures price on the crude oil. This happened close to expiry.

Due to the lockdown, the demand for crude oil fell significantly. But, there was no cut on the supply of crude oil. As there was no demand for crude oil, the price of oil fell. And, the investors who had bought crude oil futures had to take delivery of thousands of crude oil on the expiry day. They do not want to take delivery because there is no demand for crude oil and they end up storing barrels of crude oil until demand picks up. The storage of crude oil costs significantly higher than the value of crude oil.

So, the demand for crude oil futures fell. Investors who were long futures contract wanted to get rid of the futures contract fearing delivery. So, they started selling futures contract. The selling pressure caused the futures price to go below zero into negative zone.

The negative value implies, the seller would give money to the buyer of crude oil along with barrels of crude oil. Sounds like a great deal right? But wait, if the delivery is taken, then the buyer would have to spend money on storing thousands of barraels of crude oil, which is worth close to nothing. Now it makes sense why the futures price of crude oil went negative.