Blog | Commodities

Urgent Market Update: Oil Prices Crash

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The price of oil crashed into negative territory mere days ago. Uncover why it happened and how to prepare for the fallout.

This is a very different blog than I usually write. The purpose of this blog is to provide the education and data you need to navigate this chaotic world right now. You might have noticed the word “Urgent” in the title. That is because this blog is about right now! This is about the present and if you are in the markets, or are interested in taking advantage of the oil crash happening as I write this, then this blog is urgent!

As you may know, I love investing in oil. I invest in many oil wells, not only for the cash flow but also for the tax incentives. However, most people invest in oil through a different channel called the stock market. For that reason, I’ve asked Andy Tanner, my Rich Dad Stock Advisor to co-write this with me so we can help as many people as possible right now.

[URGENT ACTION REQUIRED] Watch Andy's full video on why this unprecedented drop in oil prices could have lasting effects on your financial health.

If you watched the market the past few days then you've seen the oil price crash and drop to record lows. For most investors, this looks like an amazing time to buy and make a killing.

But as we began our due diligence and investigated the situation to figure out how we might also take advantage of it, we saw some alarming factors. Instead of an easy win, this oil setup is starting to look like a dangerous trap.

What’s going on with oil prices?

Before we dig in too far too fast, let’s begin with two very simple statements.

First, greed is not a reason to buy something and secondly, panic is not a reason to sell something.

Put another way, do not trade things you do not understand.

If you don't know anything about oil, or trading futures or ETFs then you better get educated before you start buying oil. Just because oil is incredibly cheap doesn’t mean now is the time to buy. Doing so is a recipe for disaster. Do not mess with things you do not understand.

The best opportunity is destroyed by a bad investor. Likewise, a bad opportunity becomes profitable with a great investor.

So let’s get some knowledge pouring in so we can determine if we should be investing in oil right now, and if so which strategy we should be using.

Stocks are simply ownership in a company.

Bond is short for bonded. It's a contract that obliges one to another. If you buy a U.S. bond, you are loaning money to the U.S. government. The U.S. government is then obliged to repay you at an agreed upon time in the future.

An option is an agreement where you have the choice to buy or not buy in the future. It is a promise to allow you to buy at a predetermined price by a predetermined time.

A future is almost like an option, except here you must buy at the predetermined price at the by the predetermined time. There is not an option to buy.

For example, let’s say Gary is a corn farmer and you are the CEO of Kellogg's. Gary wants to sell you his corn for cereal. Wouldn’t it be great if Gary could grow his corn knowing that you would buy it every time? And wouldn’t it be great if you didn’t have to find new corn farmers every time you needed corn? Of course, it would. That’s why we make an agreement between you and Gary.

By agreeing to the futures contract, both parties get the advantage of offsetting price fluctuation. You will charge Gary a little bit less for his corn because you get the peace of mind knowing you can get rid of it all. No waste. You might pay a little more for the corn knowing that the price in the future won’t go through the roof.

So we make a plan that gives both you and Gary stability.

Now, you have made a promise to buy Gary’s corn. You must take delivery at the agreed upon future date. And Gary must sell his corn at that future date for the agreed upon price.

That's why they are called futures contracts.

Simple so far, but here’s where it can get tricky.

Oil prices and oil futures

There's a market where people will trade these futures. You made a promise to buy Gary’s corn, but you can also sell the promise to someone else.

So basically, as the price of corn fluctuates, you could say, well, I made a promise to buy corn from Gary but I'm going to sell that promise to someone else, and they will pay for the corn and accept delivery.

Here's the problem with trading commodities like corn or oil. You have to store it. Oil is toxic, it's smelly, it's flammable. It doesn't last forever. It can go bad.

So a lot of people would like to be able to participate in the investment of oil. They want to speculate and gamble in an effort to make a profit, but they don't want to own oil.

Now what happens if you have promised to buy oil but you have nowhere left to store it? All your tanks are full. To make matters worse, the consumption of oil has gone way down due to the Coronavirus and the shutdown of the world economy. You can’t even get rid of what you do have and let alone what you have promised in the future.

Now let’s add more gas (pun intended) to the fire.

Russia and the Middle East get into a supply war. They both start pumping so much oil that they drive the price down and hopefully, all their competitors out of business. Let’s say their plan works. They made oil prices so cheap that the U.S. stopped fracking (which is very expensive) because of the suppressed oil prices set by Russia and the Middle East.

With that in mind, we need to understand how ETFs fit into everything.

ETFs and the 2020 Oil Crash

ETF stands for exchange traded fund. Trade being the key word. ETFs are built to trade. They're not built to buy and hold. You can invest in them, but you must be careful because of how they work.

For example, let’s say you own a gold ETF. Guess what? You don’t own any gold. It’s not like a stock where you own part of the company. Instead of owning a piece of gold, you own a small piece of a company that owns some gold. You will never see the gold. You don’t even own a piece of it.

This brings us to the oil ETF called USO. The USO does not buy oil. They buy oil futures contracts. This is very important.

USO promises to buy and accept delivery of oil. Right now there is too much oil. The USO has no place to store the oil they have promised to buy.

How oil prices can go negative?

This blog is being written April 21, 1010. Yesterday, there was a really weird dynamic where oil prices went negative. Basically, the USO could not take delivery of the oil, so they dropped the price in an attempt to find someone to take the oil from them. But no one wants it. So the price of oil dropped off a cliff.

By now, I’m sure you understand that we have a basic supply and demand issue. The world has too much supply and not enough demand. Why not?

Airlines are not flying. Bus stations are closed. People are not driving.

All those activities that normally have a demand for oil and need delivery of oil are suddenly saying they don’t want it. They don’t want to accept delivery of the oil.

So those that own the futures contracts (like the USO) are in a panic and saying if we don't sell it, we're going to have it delivered at us. The contracts suddenly went negative because they had to pay someone else to accept the delivery of the oil. They literally had to pay to get someone else to accept delivery.

What does the company with too much oil do? Remember, they can’t dump it, burn it or destroy it. But they also can’t stop producing it. You can’t simply turn off an oil pump in the Gulf of Mexico. You’ll never get it started again. So the oil producers have to start paying people to take their oil from them. And so these oil companies, in many cases, can and will go bankrupt.

Review what negative oil prices mean

So let's review this again. We've got a guy that makes a promise to buy and take delivery of oil. But the world suddenly changed and now there is no consumption (demand) and a lot of supply. He made his futures promise a long time ago. He was planning for a different world than what we live in right now.

He thought the world would be using the oil he promised to buy. But the world changed and as things have gotten worse and worse and it's become quite apparent that the world is not normalizing fast enough. And so they've been selling and selling and selling.

The good news is that it's a very short term issue. Right now we have millions of barrels of oil out there. But the short term consumption is so low there is no demand for it while there is an abundance of supply.

That's the basis for all of the issues in the oil market right now. So, if you are thinking, buy the oil company shares while they are so low, then you need to realize that there is a chance they will be going bankrupt soon and you’ll be left with nothing.

Or maybe you want to buy the USO ETF now while it’s low. Well, when is it going to return? When is the demand going to match the supply?

How long until people begin flying again? It may be soon, but it’s also possible that the world is learning to conduct business meetings using Skype and Zoom rather than taking the time and expense of flying to meet face-to-face. Are people going to work like they used to with 90 minute commutes or have they learned to conduct business from home and save themselves from the long, expensive drive?

The lesson I want to drive home is to not jump into an investment without thinking these things through. Oil may be on sale right now, but it might also just be the new norm.

If you find yourself frustrated, don’t feel bad. Investing is not supposed to be easy. When you invest you are earning your money. It’s not a gift. It’s the challenge that makes it fun and rewarding.

Original publish date: April 21, 2020

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