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The Saga of Oil Recovery From Its Historic Plunge a Year Ago

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A year ago on Apr 20, in a bizarre turn of events, WTI crude futures took a dive and it was, well, worth less than nothing. On the NYMEX, May WTI crude fell $55.90, or 306%, to finish at -$37.63 a barrel. That was the lowest ever settlement for a front-month contract and the largest one-day drop on record. The emergence of sub-zero price simply implied that sellers had to pay buyers to take their oil.

Let’s dwell a little more on the epic crash, the commodity’s stunning rebound and whether a repeat of the negative oil prices is likely.

Crude’s Descent Below Zero

In the energy markets, oil futures are basically contracts or agreements to buy and sell a specific amount of the commodity (in physical form) at a given time in the future. This is a sort of financial instrument that determines the price of oil.

Last April, the nearest-month (May) oil contract suffered from a perfect storm of bad news — the coronavirus-induced demand slump, a devastating price war between Saudi Arabia and Russia, and a supply glut. The lack of significant storage capacity amid the oversupply put further pressure on prices. As a result, the oil market went into one of its most precipitous crashes in history with the benchmark crude contract for May going into freefall.

Apart from dire fundamentals, it indicated that traders and speculators were desperate to liquidate their contracts at whatever realization they could fetch. That way, they could at least avoid taking physical delivery of the commodity with no place to put it.

Implications of Negative Prices

With the traditional inland storage facilities to store oil running out, traders were scrambling to sell their contract before having to physically acquire the oil and keep it. On the other hand, whoever agreed to buy the contract would have had to take physical delivery of thousands of barrels of oil and put it somewhere.

That was a nightmarish prospect then. With no place to put the crude amid the coronavirus-forced demand destruction and collapse in prices, no one wanted to take delivery.

The massive plunge in the May contract didn’t imply that all oil producers had to pay buyers $37.63 for every barrel of crude they churned out. It just meant that market participants who bet their exposure on the price of oil were forced to shell out money to free them from a contract they didn’t want to honor.

The Fuel’s Remarkable Rebound

Taking investors on a roller coaster ride, crude has made a stunning rebound — from the depths of minus $38 a barrel in April 2020 to reclaim a nearly two-year high above $66 in March.

The commodity has spent much of the past few months trading higher on continued vaccine-related developments and their successful deployment around the world, offering hope of an earlier-than-expected pickup in demand. The OPEC+ cartel’s calibrated production policy has also driven up oil. In its recent meeting, member countries of the OPEC+ group — a coalition between OPEC countries under kingpin Saudi Arabia and non-members led by Russia — decided to gradually loosen the output cuts from May through July, reflecting their confidence in the fuel’s demand. Easing coronavirus infections, signs of robust demand in the world’s second-largest oil consumer, China, and the passage of the $1.9 trillion stimulus bill are the other positives in the oil story.

The renewed confidence can be gauged from the fact that the Zacks Oil/Energy sector has gained 15% so far this year, outperforming the S&P 500 Index’s 11.7% appreciation. In fact, some of the major gainers of the S&P 500 this year include energy-related names like Diamondback Energy (FANG - Free Report) , Marathon Oil (MRO - Free Report) , EOG Resources (EOG - Free Report) , ExxonMobil (XOM - Free Report) , Occidental Petroleum (OXY - Free Report) and Devon Energy (DVN - Free Report) .

Diamondback is the top-performing energy stock with a gain of 53.45%, followed by Marathon (51.57%), EOG (37.50%), ExxonMobil (34.13%), Occidental (34.03%) and Devon (33.67%). Meanwhile, the only energy representative in the 30-stock Dow Jones industrial average, Chevron (CVX - Free Report) , carrying a Zacks Rank of #1 (Strong Buy) — is up 19.9%.

You can see the complete list of today’s Zacks #1 Rank stocks here.

Could the Dizzying Drop Happen Again?

Most industry observers saw last year’s drop of oil prices into negative territory as more of a technical issue that stemmed from the way futures contracts are written. When oil went below zero, the contract was set to expire the next day and the seller was contract-bound to deliver the oil to the buyer at a pipeline or storage facility. This is where things got tricky.

A number of traders and brokerage firms, apart from investors, were caught off guard by the negative prices. Subsequently, they had to fine-tune their risk-management algorithms, while clearing houses limited the bets of retail traders. Meanwhile, the oil exchange traded funds (“ETF”) widened the risk horizon by putting a ceiling on contracts moving into the front months. Therefore, a repeat of the plunge below zero looks unlikely though it is far from guaranteed. 

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