Negative Oil – by BGE
All sorts of impossible things happen all the damn time on Wall Street. Negative interest rates? Pay for the privilege of lending money, crazy talk. Well, right now you would pay Germany 0.436% per year for the privilege of lending them money for ten years. There’s a good reason for this, but it seems mad. On Monday, 20 April 2020 the price of oil, or to be accurate May 2020 WTI, went negative. At one point, you would be paid $38 to take a barrel of oil off a desperate speculator. How did this happen? Well, there are real supply and demand reasons that prices are low — the lockdown, Saudi Arabia vs Russia – but the reason they went negative is that we are talking about paper oil not physical oil.
I’m not an oil guy, or a commodities guy, I’m a credit guy, but futures are ubiquitous in the markets. When we speak of oil prices we are not speaking of what you pay to take possession of a barrel, we are talking about a benchmark futures contract price. Futures are financial derivatives that oblige the buyer to buy or sell some underlying asset at a predetermined price and date. They can be contrasted with options, which are financial derivatives that give the right, but not the obligation, to buy or sell. There is a futures market for just about anything that is delivered in the future: corn, oil, pork bellies, stocks, bonds. Futures are standardized, trade on exchanges, and are regulated by the CFTC. There’s a thing called a Forward, which is like a future, but is traded over-the-counter with custom terms and conditions.
Futures are used by sellers (e.g., oil producers or farmers) to hedge the price of an underlying asset to prevent losses from a decrease in price. They’re used by buyers (e.g., airlines) to prevent losses from a future increase in price. They’re used by investors (I’m going to call them investors since the distinction between investment and speculation is in the eye of the beholder, like scholar) to speculate on the direction of prices, either up or down, using leverage. If you ever “locked in a rate” on a home mortgage, you’ve basically entered into a futures contract (ok an option.) Essentially, the hedger is transferring the future price risk to the speculator This is a zero-sum financial transaction, but not a zero-sum social transaction, since both sides gain. The hedger benefits from the locked in price and the speculator benefits from, or is damaged by, the volatility.
There are a couple of terms that you need to know. The spot is the price of a fixed quantity of an asset delivered at a specific place, right now. Backwardation is when the futures price of an asset is lower than the spot and is often a sign that investors expect the price to fall over time. Contango, a word much loved by word nerds is when the futures price is higher than the spot and can be a sign that investors expect prices to rise but is usually associated with the cost of carry (e.g., storage, spoilage.) Markets tend to be in contango, but prices usually converge to the spot as the contracts approach expiration.
Contango can be weird. It can cause a bet on rising oil prices into a loss, even though prices increase, if it is steep enough. Not long ago, contango in oil was so severe that investing in the front month created a 15% monthly headwind. Oil had to go up more than 15% for you to profit. Some financial advisors will tell you to include a small commodities position to “hedge your life.” Good advice, but the ETF’s available to the average person won’t work because of contango. Caveat emptor. I’ll come back to this since it’s a contributor to the negative prices.
Last bits of background. Most investors are not interested in delivering or receiving the underlying asset. What they’re interested in is profiting on the changes in price. Thus, most contracts are closed before expiration, which is usually the third Friday of the month, but May 2020 WTI closed on Monday. These contracts usually contain a provision to roll the contract forward. Most investors buy on margin. That is, they use borrowed money. The initial margin can be only a few thousand dollars to control 1000 barrels of oil. If the position starts to lose money, the broker will ask the investor for more money to cover the loss. If the investor doesn’t do so fast enough, the broker sells out the position and the investor has to make up any loss. This is called the maintenance margin. These, and the notions of limit up and limit down, which I won’t cover, are key things that make futures very volatile. The position doesn’t have to move very much to cause large losses.
To oil. Most people think the price they see in the papers is the price of oil. Nope, there is no “price of oil.” Oil has different grades, different storage requirements, different everything. A barrel of oil delivered in NY Harbor is different from a barrel of oil delivered in Bahrain. A barrel of oil from the North Sea is very different from the sludge you get from Mexico and Venezuela. What you see in the papers is the price of the “front-month” oil futures contract trading on the NY Mercantile Exchange for a barrel of West Texas Intermediate grade oil delivered on a specific date at Cushing, Oklahoma. Phew. This is the US oil price you see in the papers. You might also see something called Brent Crude, which is the same sort of thing for North Sea oil. There’s something called spot, but it isn’t very important to the markets. The US Energy Information Administration (EIA) collects weekly spot and future prices from all over the world, so you can see what this means if you’re interested.
Demand for oil has collapsed because of the lockdown. At the same time, OPEC has been breaking up and Saudi Arabia and Russia entered into a mutual destruction pact to increase production. The conspiracy theory is they did it to wreck US production since the US becoming a net oil exporter is the most important strategic event since the fall of the Berlin Wall. We don’t have to keep the Strait of Hormuz open, we just have to be able to close it. In any case, there’s oil sloshing about all over the place. Tankers are sitting fully loaded and Cushing, OK is about 2/3 full. It’s very difficult to turn off an oil well and, if they have no place to put it, they’ll have to burn it off.
Let’s go back to two things from above. First, most of the trading in oil is done by professionals who buy or sell the futures contracts themselves all day every day. However, there are also Oil ETF’s, that allow an investor to buy into this market without being a professional. They are derivatives of a derivative in fact. Nothing wrong with this per se, but there had been a large flow of funds into these ETF’s by individuals and hedge funds. A pro will hedge his position, but the ETF’s have tended to be one-way bets. Second, these ETF’s tend to invest in the nearest date contract, in this case May 2020, which expired on Monday.
There are all sorts of monkeyshines around expiration dates as the traders try to shove the prices around. In a leveraged trade small changes can lead to big pay-offs. Some of that was in play here, but what we had was what is called a “crowded trade” where there are too many people who have made the same bet. If that bet goes wrong, you get a rush toward the exits and, occasionally you get the Triangle Shirtwaist Company fire.
There were a lot of outstanding long-contracts and those holding them had to either take delivery or sell the equivalent amount of oil, (i.e., pay someone else to take it.) There are few buyers of oil, that’s what dropping prices mean, so selling was difficult to impossible and the investors typically have no ability to take delivery – space in Cushing does no good to a trader in NY. The pro’s knew this, so they shorted the contract, driving down the price and forcing the longs to sell at still lower price, which caused a spiral down in price. You might have heard of a short squeeze, this is a long squeeze and contango gone wild.
At the end of the day none of this really matters. This was a problem in paper oil, not oil. Some hedge-funds lost money and some got wiped out, we’ll see over the next couple of days. But, Brent didn’t do this, shares in Exxon barely budged on the day and are up today and the June 2020 WTI contract is selling for about $15. Once the lockdown ends and demand returns the storage issue will ease and this will become a Wall Street legend like the day the Hunt’s tried to corner the market or the Crash of ’87. It does illustrate the only eternal Wall Street wisdom, no-one knows nothin, and is an object lesson that you should always understand what you’re buying.