There was this news report in the last few days about the price of oil going negative to -$40 per barrel, giving the impression that oil producers were now paying people to take their oil. Of course, that could not be strictly true. It is not as if your local gas station was paying customers to fill their tanks. In actuality, gas prices were trading normally, though the prices have been dropping due to the lowered economic activity because of the pandemic leading to an oil surplus.
But this story does illustrate one of the pitfalls of what are known as futures trading contracts where, as I understand it, people enter into contracts to purchase a given amount of an asset at a certain price at a specified date and time in the future, irrespective of the price at the time that they entered into the contract. In this case, the asset was oil and the due date when the contract fell due was Tuesday.
An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.
Many traders on futures contracts have no interest in actually owning the oil. Instead they are betting that the price of oil will rise before the expiry date and so they can sell the contract to someone else at a profit. The buyer will in turn sell that contract before the due date.
Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may interested in capturing a profit on the price moves of oil.
For example, it is January and April contracts are trading at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil.
The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1000). Alternatively, if the price drops to $50 and they close out the position there, they lose $5,000.
But what happened was that the price of oil has been dropping and holders of the contracts may have held on to them for too long, hoping that the price may go up and reduce their losses. No one wanted to buy the contracts because the oil storage facilities were packed due to the low demand. This meant that the holder of the contract at the specified time would have to buy the oil at the contracted price and, worse, would have to take physical possession of the oil, which of course is impossible for most of the traders to do and those who could would have to find expensive new storage facilities for it. So the owners of these contracts were desperate to unload these contracts on Tuesday and were willing to pay people to buy them, hence the negative price. Presumably the final purchasers had access to storage facilities.
I heard about futures contracts a long time ago where the asset concerned was pork bellies. Apparently pork bellies are a very popular food item. I was intrigued by the idea that if one mishandled the futures contract for it and did not unload it in time, one might find truckloads of pork bellies dumped on your front yard. I suspect that that is not quite what happens but that idea gripped my imagination.
This is reason #347 why I steer clear of any direct involvement with the stock market.