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The financial markets are dysfunctional - the price of oil went below zero.

01 May 2020

Written by Ralph Hazell

Economics

The enormous drop in consumption and economic activity is having some strange side effects, recently it was the Oil market’s turn. Oil storage facilities around the world are full to capacity and with the lockdown in most countries still in place people aren’t driving their cars, thereby disrupting the normal cycle of oil production and consumption. Then add to this the leverage inherent in the futures markets, resulting in a dangerous cocktail of hidden risks.

Futures markets exist to help businesses manage the risk and uncertainty of having to buy or sell oil in the future. For instance an airline might forward buy its fuel requirements for years in advance to make their financial planning a lot easier. But in reality, most of the trading in the oil futures markets is speculative in line with the uber financialisation of everything that has crept into all areas of economic activity.

So, how can the price of oil for future delivery go negative? This is partially explained that there not only is a cost to storing oil (which has obviously gone up a lot with the lack of availability) but also the speculators not being able to get access to any storage facilities which meant that they could not possibly take delivery of the oil at the agreed date in the future, therefore they had to sell their future delivery contract at any price to someone who could take delivery.

This took the New York traded Oil contract for May delivery down from $18 a barrel to below minus $40 a barrel on the single trading day of April 20th. This is a once in a 100 years black swan event.

So, if something like this could happen in the Oil markets, why not in other commodities - perhaps even in the gold futures markets?!

I would say that the gold futures market is a prime candidate for something similar to happen - but storing gold wouldn’t be the problem. There are plenty of secure vaults around the world, besides, a tonne of gold valued at £44 million on writing this article, would only take up a few metres square in space in a vault - that’s 80 good delivery bars of 12.5 kgs each.

So the problem wouldn’t be storage but it might be the sudden realisation that there isn’t enough actual physical gold to back up all the paper contracts. In a way the complete opposite of what happened to oil where people couldn’t take delivery, what if the gold market became dysfunctional because everyone did want to take physical delivery.

How would this work in reality?

Gold is globally recognised as a safe haven asset that people want to own in times of uncertainty such as the current economic environment. The easiest way to get exposure to gold has been for a long time through a regulated financial instrument such as a gold ETF (exchange traded fund) or a gold futures contract. It is estimated that there is 100 times more gold outstanding in these security contracts than there is physical gold stored in vaults.

This can be fine when the markets are functioning as expected, but within all of these ETFs and derivatives contracts there will be significant counterparty risk. If the financial markets become even more dysfunctional the value of gold ETF’s and futures may not reflect the price of physical gold.

This could play out in some strange ways. The gold futures markets are used to hedge the price of gold going down as well as a way to gaining exposure to the price going up. If all the short sellers needed to exit, we might see a huge price rise in the futures price.

Ultimately there is nothing like owning physical gold directly with no counterparty. This is part of what we offer with Tally.