Oil 101: Why Are Prices Jumping, And What Are 'Futures'?

AILSA CHANG, HOST:

The coronavirus has shut down factories and businesses, grounded planes and kept drivers off the road. That has translated into a massive slump in demand for oil.

MARY LOUISE KELLY, HOST:

Now, supply of oil, on the other hand, has not been a problem. Producers are still pumping away in Russia and Saudi Arabia and right here in the U.S. You might think that imbalance would mean the price of oil is moving in just one direction - downwards.

CHANG: But a chart tracking oil prices now looks more like an especially nauseating roller coaster. Prices dropped to negative $37 a barrel last Monday.

KELLY: This week, though, they have been whipping between $10 and $20 a barrel. The reason? The trading of oil futures, which NPR's Paddy Hirsch says is kind of like a financial game of hot potato. He's here now to explain. Hey, Paddy.

PADDY HIRSCH, BYLINE: Nice to be here, Mary Louise.

KELLY: So oil futures as hot potato. Start with what is a future exactly.

HIRSCH: A future is a way for a producer of a commodity to lock in the price of those goods in advance. It's a contract to deliver a certain amount of that commodity, which could be oil or strawberries or celery, on a certain date at a certain price, so at some point in the future. And by entering into this contract, the producer is guaranteeing a revenue stream a month in advance rather than having to wait till the day of sale to actually try to sell your strawberries or potatoes or whatever. And that removes uncertainty from the producer's operations and makes it easier to run their business.

KELLY: And then what how does Wall Street get involved and turn all this into a futures market?

HIRSCH: OK. So these contracts are written, right? They're actually pieces of paper, and they can be traded just like stocks or bonds. And speculators use them to bet on the way that the oil market is moving. So let's take a contract to deliver 100,000 barrels of oil at $10 a barrel - that's a million dollars. So I might pay a million dollars for that contract at face value today hoping that tomorrow the price of oil will be above $10. So say it goes to $12. I can then turn around and sell the contract for $1.2 million, giving me a $200,000 profit. Very nice, right?

KELLY: Definitely, yeah (laughter).

HIRSCH: Sometimes, of course, the price goes down. So I can lose money, right? So this is where it's kind of like a game of pass the parcel, where you've got this paper that traders are handing around, trying to sell it off, and they're handing this contract off. And depending on whether the price is going to go up or down, they're going to get a nice surprise or a nasty one every time they rip off the paper.

KELLY: OK, so apply all this to this moment we are now in. As we mentioned, oil prices mostly going down, in some cases way down - last week, in fact, negative. What is going on with this?

HIRSCH: Yeah, they're whipsawing all over the place right now. And the thing about the futures market is, is that it kind of floats on top of the actual market, the real market where people actually take possession of oil because the traders who are trading these contracts don't actually want the physical oil. It's black, and it's sticky, and it comes in barrels, and they don't want it sitting outside their house. They just want to bet on how the price moves.

But the future is a contract to actually deliver that oil. And usually, this isn't a problem - right? - because you can always find someone to buy this stuff, whether they use it in refineries or they store it somewhere. But right now, as you said in the introduction, refiners aren't buying very much, and there aren't very many places left to store this stuff. This has really freaked people out. And it means that pass the parcel has turned into a game of hot potato. They're desperate to get rid of this paper. They're like, oh, my gosh, take $50 dollars for it. No, take $30. No, just take it. In fact, I'll pay you to take it. And that's why it dropped so low last week.

KELLY: That is Paddy Hirsch, editor of our daily economics podcast The Indicator from Planet Money. He is also the author of "Man Vs. Markets," a book explaining the financial system. Paddy Hirsch, thanks for explaining all that to us.

HIRSCH: It's my pleasure. Thank you. Transcript provided by NPR, Copyright NPR.