Last week was a historic week for oil prices. We have seen negative oil prices for the WTI future prices. It wasn’t the first negative oil price, there were some marginal crude blends seeing negative numbers. On the products side, there were some occurences of negative valuations. Before giving conclusions, we have to understand what has happened at the technical level.
On April 8th, 2020 CME Group has published an advisory notice titled “CME Clearing Plan to Address the Potential of a Negative Underlying in Certain Energy Optons Contracts”. The notice summary includes a part with “if major energy prices continue to fall towards zero in the coming months…”. So if someone has the right to claim an advance foresight of negative oil prices, it should be CME Group.
According to CME’s “Crude Oil Futures Calendar” the settlement date for the May contract is 21st April 2020. For those of you expecting another wave of negative prices, the next settlement is on 19th May 2020. The options contract settle on the 14th May 2020. Future contract’s delivery procedure states that “Delivery shall be made free-on-board (F.O.B.) at any pipeline or storage facility in Cushing”. That leads to “physical delivery” obligation of the contract if you do not roll.
In the most basic level, on the last day of the settlement of May 2020 WTI oil futures contract, the final contracts of that day fall to negative territory. There may be several reasons. The foremost of it is due to physical settlement nature of the contracts. When you do not want a physical settlement and you can not find a counterparty to buy your contract, the price of the contract further aways from the physical oil price and reflects storage costs of that time.
We get used to abundance and scarcity of oil and relevant oil prices. But we have never seen the scarcity of “storage space” before. Although the storages were not full, they were booked. There is always the possibility of storage owners’ intention to squeeze the market. Scarcity may pave the way for exercising market power, whether it is oil or storage it does not matter.
So there is a coupling of oil market with storage at the last day of thensettlement. Then comes the next question. Can we conclude that there was a market manipulation or malfunctioning computer algorithms? This may not be easily concluded. On CNBC, CME Group chief Terry Duff says there were around 154000 contracts on Monday, less than 80 of them settled at zero price, 10% settled at negative prices. Duff asks “why the oil industry didn’t buy this negatively priced oils if it worth more?”. This legitimate question brings us to the main question.
Duff puts a simple logic : “why did it go below zero? because no one was willing to step up and take that product at the price of zero because they knew their costs would be higher than that”.
The second issue is about US Oil Fund. The fund has already rolled its May presence before the historic Monday. The fund was a heavy weight in the market with a share of 20-27% of futures oil contracts. Their departure from May contract may have dried up the liquidity for May contracts but USO publishes its movements beforehand.
After the historic crash, on the 23rd April, CME has imposed new position limits on the contracts. USO’s positions in June contracts most probably was over that limit. And within a week they changed their positions 2 times and reported to SEC. As of today, USO has filed another 8K to the Securities and Exchanges Commission about their position limits. This time the contract diversity included even June 2021. The new portfolio is July 30%, August-September-October-November-December 10% each and July 2021 10%. The new position will be rolled into within these 3 days: 27-28-29 April. The next three days will be shaky too. But then some stability from the ETFs side will be provided. We will see the bare force of fundamentals then.
After these position moves, we will see whether negative prices will repeat or not. According to CME group negative prices are always a possibility and part of market functioning. The negative prices will be determined by two things: the hedge positions of the producers and storage costs or storage limits of the next month. If oil production was flexible enough we may not have seen negative prices.
The main message from last week was how pricing regimes work and at which boundaries these regimes couple with other markets. As in the oil prices, specifically about a physical settlement contract, after a certain range prices should reflect storage costs. That is not a surprise, however if the other coupled market -storage/pipeline/tankers – is in scarcity that may show symptoms of manipulation through exercising market power.
One last issue is probably the amateur investors, who were not aware of the physical settlement of the contracts. According to Bloomberg, some Chinese investors woke up with obligation to pay over their contracts after Monday’s negative prices. Some brokage firms has declared losses. Trafigura and Carl Icahn has declared that they bought some of this negatively priced oil. The most famous professional oil trader Pierre Andurand find these times “very dangerous”.
The leading academic expert on the financial sides of oil markets, Dr Bahattin Büyükşahin has told us some important conclusions from previous episodes. The herding is real, these markets are for price discovery they may not reflect real prices. And during times like these, these effects may amplify and may go astray. 20th April 2020 may be a historic moment but will not be an exception.