This episode, Mak & G discover what ‘future contracts’ are, why they exist, and how future contracts for oil went negative.
Hearing that someone would give you money if you take their oil sounds crazy.
Why would anything ever be negatively priced? Why would anyone pay you to take something?
This “Money With Mak and G” podcast episode, Mak & G look at what ‘future contracts’ are, the benefits of using futures contracts, and why future contracts for oil went negative…
“The price has to do something with supply and demand.” – G
“I would have never expected a futures contract to go negative but it did! The oil had to go somewhere and nobody wanted it.” – Ben Jones
01:26 – Why I bought a limo.
04:18 – What a ‘futures contract’ is.
06:12 – The requirements in a futures contract and what ‘standard quantities’ are.
06:49 – When futures contracts were invented.
07:10 – The benefits of using futures contracts.
08:46 – The standard quantity for an orange futures contract.
09:40 – How much oil gets used every day.
10:17 – Where oil is stored and how many barrels can be stored in the world.
11:11 – How much less oil we used during the pandemic and why oil supply increased.
12:18 – Why oil futures contracts went negative.
13:28 – The increased cost of storage.
15:42 – The different ways oil is used and what it produces.
Connect with Ben Jones:
MAK: Grant, did you just hear what they said on the tv?
GRANT: I must not have. I thought they said a barrel of oil was being sold for close to negative $40?
MAK: What the heck does that mean? Instead of paying $40, are they going to pay ME $40 to take a barrel?
GRANT: That can’t be true. That makes NO sense. Is this due to Coronavirus?
MAK: Dad says things are happening now that we have never seen before. Maybe that’s it.
GRANT: Well, he has a lot of “wisdom”, because we both know dad is ancient!
MAK: You got that right. He was born before 2000!
GRANT: So, what’s going on with all this oil stuff? Isn’t oil how they make gasoline for cars?
MAK: That’s what I remember. So, how many gallons of oil are in a barrel? Do you know?
GRANT: I don’t have any idea. If you make gas from oil, how many gallons of gas can you get out of a barrel?
MAK: I don’t know the answer to that one either.
GRANT: Well, the price has to do with supply and demand, right? Dad said that’s always the reason.
MAK: Yeah, he does say that a lot. Sounds like something we can work with.
GRANT: Maybe we can ask dad. I just saw him outside. What on earth is he doing?
MAK: Is he washing a car? What is that thing? It’s soooooo long…
GRANT: I’m not sure what’s going on. But, I do know if we need answers, he should put that hose down!!!
MAK/GRANT: DAD??? Can we talk about oil prices???
DAD: Hey, why are you guys yelling at me?
MAK: We were trying to get your attention because we wanted to ask you some questions.
DAD: About what? I’m a little busy filling up my jacuzzi.
GRANT: What? Is that a hot tub back there?
DAD: Sure is.
MAK: Wait a second, this thing seriously has a hot tub where the trunk should be?
DAD: Sure does. Don’t you love it? I just bought it.
GRANT: What exactly is this monstrosity?
DAD: It’s a stretch limousine, can’t you tell? Wheels, engine, windows … I had it upgraded with the optional jacuzzi. I could have gotten one with a helipad, but I decided against it.
GRANT: A helipad? Seriously? You don’t even have a helicopter. So, you seriously bought this thing? It has to be at least 40’.
DAD: Sure, why not.
MAK: I’m going to try out the jacuzzi. How awesome is that? Can I go in there?
DAD: Sure. The limo can easily hold 15 people. All your friends at one time. What do you think?
GRANT: That’s soooo cool. Ooh, ooh, check this out. I … LOVE … IT …!!!!
DAD: Mak, watch this. Grant’s going to freak, and fall all over himself when he sees what’s inside.
MAK: Are those video games?
DAD: Yep. There are two 40” TVs with an XBox, PS4, and a couple other systems in there. I had a shelf put in that holds 100 games.
GRANT: And, it’s already got a fridge stocked with drinks and food. I can’t breathe … All you need is a bed, so when I get tired I can just pass out and do it all over again. This is so ….
DAD: You got that right.
GRANT: Did you buy this for us?
MAK: Why would you buy such a large one?
DAD: Like I really need to explain it. But… I have two reasons, and it’s not Mak & G!!! First: I’ve always wanted one since I was 10!!! Second: it’s a ton cheaper to run now that gas prices are plummeting.
GRANT: You’re my new hero dad!!!
DAD: Thanks buddy. Hey, what was the reason you guys came outside to talk to me?
MAK: Actually, we were really curious about something we heard on TV, we thought you might know something about it.
GRANT: And, it has something to do with what you just mentioned…
DAD: Well, what is it?
MAK: We just heard some really weird news on the TV. It said that a barrel of oil was selling around NEGATIVE $40.
GRANT: Yeah, that sounds absolutely messed up.
DAD: I saw that too. I’ve NEVER seen something like that. To clarify a bit, it was actually the price for a barrel of oil purchased on a futures contract.
MAK: What’s that? Did you say “sutures” contract? Isn’t that a name for “stitches” that Lexi did in Med school? It’s like sewing your skin together by bringing both sides of a cut together to heal, right?
GRANT: Mak, I think dad said a “futures” contract.
DAD: I did say “Futures”. But it’s funny that Mak said “bring two sides” together. Because a futures contract does bring two sides or parties together in order to deliver a product in the future.
MAK: Ok. I think I understood some of that. But, isn’t a “party” something you have fun at?
DAD: In this case, a “party” can be a person, a business or anyone that has an interest in “Part” of a contract.
GRANT: So, is it like ordering something from Amazon? You place the order today, and you get the product in the future?
MAK: The “parties” would be me, a person, and since I’m ordering a pound of chocolate, the other party is the company Amazon who delivers it. And, do we have a contract?
DAD: That’s a great way to look at it. In your “contract” with Amazon, they agree to deliver the chocolate, and you agree to pay for it.
GRANT: That’s simple. So, why is a futures contract complicated?
DAD: Good question. But, a real contract is formal, it’s written down and signed. You can also force someone to complete the contract. If Amazon didn’t deliver your chocolate, it’s hard to make them do it.
MAK: Well, I don’t think that’s fair. I would definitely want my chocolate!!!
DAD: I completely understand. But a futures contract requires you to do what you agree to and it’s for a standard amount of product.
GRANT: Haven’t we spoken about standards before? Isn’t a gallon of gas the normal, or standard measure when buying gas for your car?
DAD: That’s a perfect example G. The standard futures contract for oil is 1,000 barrels. Futures contracts can be for delivery much further into the future. It can be tomorrow or many months.
MAK: Ok, so there is an agreement or contract. It’s for a specific amount of product. And, it will be delivered in the future.
DAD: You got it. That was perfect.
GRANT: Ok, so when did it all start?
DAD: It started with the ancient Greeks, which is thousands of years ago. But, around 1700, the modern futures contract started in Japan for rice.
GRANT: Wow, that’s a long time ago. So, why would someone want to use a futures contract? Why were they created?
DAD: I know we’ve spoken about risk before, right?
MAK: Yeah, so?
DAD: A futures contract is really all about risk. You bring two parties together to reduce the risk for both. That’s really the main idea.
GRANT: Not following dad.
DAD: Ok, you guys both like orange juice, right?
MAK: Yep, but I don’t like that pulp stuff. It gets caught in my throat and my teeth. It makes me cough.
GRANT: It’s like sunshine in a glass!!
DAD: Well, a farmer that raises oranges, would love to lock in the price today for the oranges he’s going to have when he harvests his crop in say 6 months.
GRANT: That’s a little weird to think about.
MAK: Would that mean a farmer doesn’t know the price he’ll sell his oranges for until they are pulled off the tree?
GRANT: Whooaa. So, they wouldn’t know if they made any money until they harvested and sold their crop?
DAD: That’s right. So, how would you like to work all year raising oranges, and at the last minute, if you sold your crop for a good price, you made money. If not, you lost money.
GRANT: That sounds absolutely terrible.
MAK: Yeah, and super risky.
DAD: I agree. A farmer doesn’t want that risk. He wants to raise oranges and provide for his family. Employees know exactly how much they get each week, but a farmer doesn’t until he sells his crops.
GRANT: So, does this futures contract help with that?
DAD: Sure it does. The farmer can sell everything prior to the end of the season to lock in a price, or they can wait to see what happens.
MAK: So, what is the standard quantity of an orange futures contract?
GRANT: And, are they real?
DAD: They are real and the standard quantity for 1 contract is 15,000 pounds. So, the companies that buy oranges for orange juice would like to know the price of the biggest part of their product.
MAK: Is that so they can price their product?
DAD: Absolutely. How do you price orange juice each week if the price of oranges goes up and down? If you buy oranges with futures contracts, then you lock in the price for future delivery when you need it.
GRANT: So, that means the price of orange juice is more stable? I think I got it.
DAD: You sure do. The farmer reduces his risk on the price of his crop, and the orange juice company reduces their risk on the cost of part of their product and it stabilizes prices. Both parties are happy.
MAK: So, what’s the deal with oil?
DAD: Well, you have to ask a few questions first. Do either of you know how many barrels of oil are produced in the world a day?
GRANT: 100,000? Is that it?
MAK: Sounds like a trick question. I’ll say a million.
DAD: Actually, it’s close to 100 million. And, funny enough, the world uses about 100 million barrels a day. Here in the US we used close to 20 million barrels a day in 2019.
GRANT: That’s freaky. And, it’s just unbelievable.
MAK: I agree. I can’t imagine that many barrels being produced and used in a day. If they had extra oil, where would you put it?
DAD: Well barrels are stored in salt mines, large tanks and ships called oil tankers. An oil tanker is mostly a big tank on a boat. Do you have any idea how many barrels we can store in the world at any one time?
MAK: It has to be huge, maybe we can store 100 billion barrels?
GRANT: How about 200 billion barrels?
DAD: No, it’s actually about 1.2 billion barrels.
MAK: So, if no one used any oil, everything would fill up in 12 days, right?
DAD: Yep. That’s right. I know it’s a lot of numbers, but a barrel has 42 gallons. And, you can make about 20 gallons of gasoline from each barrel.
MAK: Dad, since we’ve been confined to home for 4 weeks, you and mom haven’t gone to the gas station once.
GRANT: With Coroana shutting down businesses that use oil, and since we’re not filling up our cars with gas, does that mess things up?
DAD: Absolutely. It’s estimated that we’re using less than half what we used to in our cars. And, it takes planning to shut down oil production. And, two countries that produce a lot of oil got into a fight.
MAK: Which countries were they, and why did they get in a fight about.
DAD: Saudi Arabia and Russia were the ones. And, it was just like the two of you when you got in a fight over the last cookie a week ago ? Do you remember?
GRANT: Yeah. Why is that important?
DAD: Well, all you had to do was apologize and you would have gotten ½ of it Grant, but you refused.
GRANT: It just wasn’t right.
DAD: Well, Saudi Arabia and Russia did the same. They were too hard headed to agree to work together for their own good and now they’re both suffering. They were talking about cutting oil production, but …
GRANT: They got in a fight.
DAD: Yep, and what do you think happened if they didn’t cut production but increased it, and demand dropped?
MAK: Lower prices. Got it.
GRANT: But, what about the oil futures?
DAD: Well, since there was no place to put all the oil they produced, it had to go somewhere. And, it was for delivery next month!!! Since nobody wanted it, demand was super low, with super high supply.
MAK: And, the price went negative, and people were getting paid to take the oil.
GRANT: Way to go Mak. Sounds like you nailed it.
MAK: Was there just a couple of these futures contracts that got sold? They’re 1,000 barrels each, right?
DAD: There were more than a few. There were 150,000 contracts that changed hands.
GRANT: Ouch! Isn’t that about $233 billion?
DAD: You got it. Isn’t that nuts? The price of gas now compared to last year is already $1 per gallon less, and it’s expected to fall.
GRANT: So, they’ll give us money when we fill up next time for storing it in our gas tank?
DAD: Nice one, but “no”, the gas pump won’t give you money like an ATM machine at the bank.
MAK: That’s too bad. I really liked that idea. One last question.
MAK: If storage is in such high demand and there isn’t a lot of supply, is the price for storage going up?
DAD: It absolutely is. Right now, they think there are 100 million gallons floating on the water in oil tankers. And the price of an oil tanker jumped about 700% or 7 times normal.
GRANT: Dude, that is beyond INSANE. Dad, you’ve said it before, it’s all about supply and demand.
DAD: And, I’ll say it again. It’s all about Supply and demand.
MAK/GRANT: Supply and Demand, Supply and Demand.
DAD: Way to go. You guys got it. I think I’m going to spend the rest of the day waxing my limo and thinking about lower gas prices.
GRANT: I’ll clean the inside dad. And definitely not play video games.
MAK: And I’ll clean the jacuzzi.
DAD: That would be perfect. Thanks for your help!
MAK/GRANT: Thanks dad!! Bye!!!!
Ben’s 2 Cents
Even though we were talking about taxes this season, we thought we’d try something a little different and talk about a current event. The Coronavirus has turned our world upside down. We’re living in a historic time and this stuff is absolutely fascinating. I would have never expected a futures contract to go negative, but it did. The oil had to go somewhere and nobody wanted it. The concept about supply and demand, as well as seeing the ramifications of how a situation has an effect on many other aspects of our economy was just too good to pass up.
We produce and use an enormous amount of oil in products from lipstick to jet fuel. When the supply continues and demand doesn’t, the market has to adjust. And, where do you put it all? These are the insights we use when investing. We understand how a situation affects a company and their profitability. This situation was clearly an anomaly. But, it goes to show when you look at the big picture of what happened, it all makes sense.
There are many aspects of cutting oil production, which make it difficult to cut it instantaneously. The Coronavirus literally dropped an enormous amount of demand over night. Many machines that use gasoline stopped running including airplanes, cars, construction vehicles and many others. I found a list of over 6,000 items that are produced from oil. Tires, golf bags, roofing, toilet seats, toothpaste, perfumes and many many others. So, any company that makes one of these 6,000 items isn’t using oil either. It will come back in some way, but with the excess inventory, it may take a while.
We hope you enjoyed this special current event edition at Money with Mak & G. Please subscribe our youtube channal, like, comment and share on this episode. We’d love to hear from you. Thanks for being here, and we’ll see you next time. BYE!!!