Without the gamble of futures markets, the oil industry might be ready to fold

The bizarre news on April 20 that oil was selling for negative $30 per barrel means exactly what you think it means: the pandemic is taking our economy into a strange and dark new place. This has never happened before.

But the news also means something else: so far at least, some of our most important financial institutions have shown they can deal with the madness. The fact that markets drove oil prices negative is actually a good reaction to a bad situation. If that hadn’t happened, we’d be in much worse shape than now.

Monday’s negative price wasn’t the actual price of a physical barrel of oil, it was the price of the “May futures contract” for a specific kind of oil, West Texas Intermediate. To understand the differences between the futures price and the actual price, I have to use an analogy that I usually hate. The futures market is a bit like a virtual casino where players make bets on the actual price of a certain type of oil as of a certain date. I’ll explain why I usually hate that analogy in a moment, but let’s work with it for a bit.

Imagine two friends, an optimist who thinks the price of oil on April 21 will be $20, and a pessimist who thinks oil will be worth $10. The futures market gives them a way to make a bet. They’d agree on a price for their bet — maybe $20 — shake hands and wait. If the price of oil is above $20, say $25, the optimist wins and the pessimist has to pay $5. If the price of oil is below $20, the optimist has to pay the pessimist the difference.

That probably doesn’t sound like a fun night in Vegas, but the people who need to buy or sell actual barrels of oil love the bet. It gives them a chance to lock in the price of oil. Paradoxically, they make bets because they hate to gamble.

Suppose you own an oil well and you know you’re going to need to sell a barrel of WTI in a few weeks. Of course you’d like to sell for the highest price possible, but oil prices are volatile. You have no idea what will happen and so you drop by the futures market casino and decide to take the pessimist side of a $20 bet. If the price falls and you end up selling your oil for $15, you win the bet and collect $5, leaving you $20. If the price goes up to $25 and you lose the bet, you pay $5 but you’ve sold your oil for $25. Either way, you’ve locked in a firm price of $20 — you’ve hedged the price risk.

If you followed that story, you understand why I don’t usually like comparing futures markets to casinos. Las Vegas provides a platform for fun bachelor parties. Futures markets provide a platform for essential investment. Without the ability to hedge commodity prices, businesses aren’t going to make the multi-million dollar investments necessary to produce commodities.

Futures markets are incredibly valuable but they’ve never been tested the way they were on Monday. For the past few weeks oil traders have been worrying about whether the storage capacity for WTI would fill up. If that were to happen, oil producers would not be able to sell oil and in fact might actually have to pay someone to take surplus oil off their hands. That sounds like an apocalyptic nightmare to many oil producers, but not the ones who hedged. They know that as long as the future markets work, they’re covered — their bets would pay off and they’ll be OK.

The question is whether the future markets will continue to work. Will events like Monday’s development leave traders unwilling or unable to honor their promises? Will the losers welch on their bets? As I finished writing, this the markets were working. The May contract actually closed at around $10. The June contract for WTI had fallen by about 43 percent but was trading at $12. So far so good.

There is one other small bit of good news in all of this. It gets a bit technical but it turns out that when the futures contracts that will soon expire — the bets that will be settled in the next few months — have lower prices than the longer-dated future contract, there is a huge incentive to buy and store oil. (Basically, traders will be able to lock in a low buying price and a higher selling price, thus guaranteeing a profit.) This creates an incentive to figure out new places to store oil — which is what we desperately need.

This is not a time for mindless optimism. But it is a time to think carefully how markets really work and why we need them now more than ever. Let’s hope those critical markets continue to function.

Michael Davis is an economics professor in the Cox School of Business at SMU.