Earlier this month, the United States experienced something unprecedented with oil prices: they went negative. As oil is typically considered an expensive commodity, such a development came as a surprise to most Americans. Especially during times of economic downturn and crumbling markets, it was hard to understand how such an occurrence could even happen.
How Oil Prices Can Be Negative
It is first essential to understand that oil is classified as a hard commodity. This means that unlike manufactured goods, it is a raw product that often serves as an input to production. While oil is still bought, sold, and traded, the markets act differently than how most people would expect. Principally, most trading happens within what economists call commodity exchanges. These markets regulate the purchasing and selling of commodities, typically done through contracts. Such contracts are formed extending into the future, meaning the price and quantity of oil are set in stone when the agreement is initially established. While this protects investors from severe directional changes in the market, it also means the future determines prices in the present. If speculators believe the market will move one way, it will impact the contracts way before such changes even occur.
Concerning negative oil prices, prices dropped due to these contracts remaining unchanged during the COVID-19 pandemic. Simply put, the world has experienced significant reductions in the need for oil. From reduced everyday transportation to a near-complete halt in factory production, there is a much smaller demand for oil. However, because these commodity futures contracts determined price and quantity before the outbreak of COVID-19, the supply of oil has remained stagnant. Because of this, oil storage in the United States continues to fill up rapidly. In fact, in an attempt to combat this excessive supply of oil, dozens of oil tankers off the coast of Los Angeles anchored as temporary storage facilities. With diminishing opportunities for storage, prices drop into the negatives, forcing demand.
Economic Impact
While cheaper gas prices and reduced heating bills might seem beneficial, low oil prices are dangerous to the country. First off, the oil sector in the United States is responsible for hundreds of thousands of jobs. When oil prices are low, it gives the companies owning oil operations insufficient capital, forcing them to cut back hours and lay off jobs if the problem persists. As a matter of fact, within the brief amount of time oil prices were negative, multiple corporations in the oil industry faced the risk of bankruptcy. Moreover, oil prices can also influence and affect the banking and investment sectors of the United States. Many oil operations rely on the funding and financial backing of wealthy banks or corporations, so when oil prices and the demand for oil decreases, it’s harder for these oil companies to pay their debt off. This not only forces these oil companies to file for bankruptcy but also diminishes the return for these firms who lent out their money, limiting future investments.
What the Future Holds
While oil prices have slightly recovered since early May, the outlook for prices is unknown. As states begin to reopen, and the demand for oil increases, more stability will hopefully be brought to the oil markets. However, the future is still cloudy. This unpredictability not only continues to impact current prices for oil but also influences how future commodity contracts are formed when the old ones expire.
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