On April 20, 2020 something happened that has never happened before. Oil prices turned negative. But what does even mean? How can something have a negative price? And what does this mean for mineral owners?
There’s a First for Everything
I know the word “unprecedented” is being thrown around a lot lately, but this one actually is unprecedented. Oil traded negative. This has never happened before. We’re witnessing history here, folks!
Oil was around $60 at the start of 2020. On April 20th, it closed at -$37. That is a 162% decline in a just under four months. The chart below shows the inflation-adjusted price of oil since 1870. In other words, since oil has been a thing. Except for a few decades of inflated prices (1870s, 1970s and early 2000s), oil has hovered around $45 per barrel +/- $20. It never really threatened to go much lower than $25 for the first 149 years. Apparently oil wanted to do something special to celebrate its 150th birthday and decided a free-fall into absolute oblivion sounded like fun.
Explain it like I’m 5
Please? Just kidding. Here’s the gist. Oil is traded on the futures market. A future is a contract and simply means “I agree to deliver X barrels/bushels/gallons/etc of something to you at this date in the future” and “you agree to pay me $Y today for this future delivery.”
For example, if an oil refiner and wants to ensure it will have 1,000 barrels of oil available to refine in August 2020, it could buy 1* August ’20 Crude Oil futures contracts today (April 2020). Whoever sold this contract to the refiner is obligated to deliver 1,000 barrels of oil at some point in August 2020 (delivery can occur on any day with the month). If the buyer and seller agreed to a price of $30 per barrel, this means “the August ’20 crude oil futures contract” is trading at $30 per barrel. *Each oil futures contract represents 1,000 barrels of oil.
The oil price quoted on the news is the “next” month, also called the “front” month, contract. So on April 20, the futures contract that traded negative was for crude oil to be delivered in May. This means that instead of buyers saying “I’ll pay you $37.63 for every barrel of oil you deliver me in May”, they were saying “You need to PAY ME $37.63 to take delivery of your oil.” But why would this ever happen?
Error: Storage Full
Crude oil futures contracts are for the physical delivery of oil. We’re talking the 1,000 barrels worth of oil are going to show up outside my front door type delivery. If you were contractually obligated to take delivery of 1,000 barrels worth of oil tomorrow, what would you do? Your first though would probably be “Okay, I need to find somewhere to store this stuff”. So you start calling around to your local “We Store Your Oil” shops, only to discover they are all fully-booked. Uh-oh. You call the shops the next county over. No dice. Next state over. Nada. There is literally nowhere for you to store this oil in the entire country. So, you call up the guy who you bought the oil from. He’s loading his truck up right now and about to hit the road with your 1,000 barrels of crude.
- You: “Hey, can you go ahead and not deliver the oil. I don’t have anywhere to put it.”
- Seller: “No, sorry. I don’t have anywhere to put it, either. I’ll be there around 3:30 tomorrow.”
- You: “No, seriously. I CANNOT take delivery. You can just keep your money AND the oil.”
- Seller: “No thanks. Like I said, I don’t have anywhere to put it and you and I have a contract. So this is your problem, not mine. See you manana.”
- You: “Dude. I’ll give you $10,000 to not drop all this oil off here.”
- Seller: “No.”
- You: “$20,000?”
- Seller: “No.”
- You: “$37,630?”
- Seller: “Fine. For that much, I’ll figure out something to do with this oil.”
You Want Negative Oil? Cuz That’s How You Get Negative Oil!
This is how we ended up at negative oil price. The contracts for May delivery stop trading on April 21 (on April 22, the June delivery contracts start trading). On April 20, there were thousands of people just like you from the example above who couldn’t take delivery of the oil because there was nowhere to store it. They had to get out of it NOW, no matter what. This meant offering more and more money for people to take the contracts, and thus the obligation to take delivery of physical oil, off their hands.
From May to June
On April 22, the quoted price of oil “popped” back from negative to around $15. This happened because the quoted contract switched to June delivery, from May. At this point, traders now have a month to buy and sell contracts, so there isn’t the same panic-selling that drove the May contract negative. Oil could certainly trade negative again, but it wouldn’t be until around May 20th.
So now that we understand why oil prices turned negative. What does this mean for mineral owners?
[Insert Shrugging Emoji]
Soooo, do we have to start cutting checks to the operator now or what? Are negative royalties really possible? Unfortunately, it is impossible to provide a blanket answer to this question. It depends on your specific lease language, what state you are in, operator agreements and a myriad of other factors. The scary thing is that the answer isn’t a straightforward “no”. The idea that mineral owners actually could owe the oil companies money is insane, but not impossible. That said, you shouldn’t expect to actually see negative royalties on your checks for April production. Prices only went negative for a couple days out of the month. Don’t get me wrong, your checks are going to look absolutely abysmal, but it’s at least better to get paid on $5-$10 oil then owing money because of a full month of negative prices.
