Matt Levine – Bloomberg – It will be a little weird if the price of oil goes negative next month. I mean, it could happen; it happened this month. The last trade of the NYMEX June West Texas Intermediate crude oil future will be on May 19; anyone long June futures after that will have to take delivery of a bunch of oil in June in Cushing, Oklahoma, where there is not a lot of space to store oil. The last trade of the May WTI futures was on April 21, and on April 20, as financial traders with long positions scrambled to get out of the contract, the price fell to negative $37.63 per barrel. Then on April 21 it was fine again, and the contract finished at $10.01. Even on April 20, most trades in the May futures happened at positive prices. But toward the end of the day, panic—or something—set in, and for a short period people were paying to get rid of their oil futures.
The June futures contract, meanwhile, was in the $20s all day that day; the next day it fell a lot, hitting $11.57, still a significantly positive number. Yesterday’s closing price was $12.78; this morning it fell to just above $10, and then recovered some. If you own June oil you still have a few weeks to get out of it without taking delivery, but the whole point of financial markets is to do this sort of backward induction. If on May 19 everyone is going to be panicking and selling June oil contracts for negative $37, then on May 18 you should not buy those contracts for much more than negative $37, which means that on May 17 you should not, etc., so the price should be negative now. The price is not negative now. This implies not only that futures traders, who want to own only abstract paper oil, think that that oil is worth $12 or whatever, but also that they expect that, as May 19 rolls around and that abstract paper oil is converted into physical oil, it will still be worth a positive number of dollars.
In other words the June futures prices imply that what happened last week was most likely an anomaly: not “oil has negative value and you need to pay people to get rid of it,” but rather “in the last few hours of trading some naive traders had to get out of paper positions and the market held them up for it.”
Now, that said, the price of June oil is very low, and also very far below the price of July oil. And markets are doing the backward induction. Financial investors who would ordinarily own the June contracts, but who do not want to be stuck with oil when they expire, are getting out of them early:
S&P Global Inc., the company behind the most popular commodity index, told clients to roll all their exposure out of the West Texas Intermediate crude oil futures for June into July with immediate effect, triggering a big drop in oil prices.
“This unscheduled roll is being implemented based on the potential for the June 2020 WTI Crude Oil contract to price at or below zero as well as the steady decline in open interest for the June 2020 contract,” the company said in a notice seen by Bloomberg News.
“We are seeing the exodus away from the Nymex WTI June contract growing,” said BNP Paribas’ head of commodity-markets strategy Harry Tchilinguirian. The move is “still motivated by the risk of negative prices that can emerge with the testing of storage capacity limits at Cushing,” the U.S. storage hub in Oklahoma.
If you are afraid of having to take delivery of oil in June, the time to sell out of your June contract is now, not May 18. Some number of investors who are afraid of having to take delivery of oil are selling now, rather than waiting for the last minute to roll their contracts as they ordinarily would. Of course if they all do that this week then there’ll be no special panic or selling pressure on May 18, and the price won’t go negative. One possible reason the price went negative last week was that no one really anticipated it going negative, so too many investors were bunched in the May contract as it neared expiration. Now that you know it’s a risk, you’re more likely to get out early.
Though arguably another reason that the price went negative last week is that people did anticipate it. Or rather, they didn’t, then they did: Negative oil prices were unthinkable, and then the exchange ran a computer test to make sure that systems could handle negative prices, and after that all anyone could think about were negative oil prices. If everyone in the market thinks about a price all at once, that price tends to materialize. Here’s Bloomberg’s fascinating recap of “The 20 Minutes That Broke the U.S. Oil Market”:
Yet on April 15, CME offered clients the ability to test their systems to prepare for negativity. That’s when the market really woke up to the idea that this could actually happen, said Clay Davis, a principal at Verano Energy Trading LP in Houston.
One important point in that story is that most big financial investors had gotten out of the May oil futures before they went negative. What happened last Monday was not a last-minute stampede of big exchange-traded funds out of the May futures; it was a relatively small number of investors stuck in the contract after everyone else got out. 1 For instance there was a Chinese retail “product that the state-run Bank of China dubbed Yuan You Bao, or Crude Oil Treasure”:
Many things about the explosive, flash-crash-like nature of the sell-off are still not fully understood, including how big a role the Crude Oil Treasure fund played as it sought to get out of the May contracts hours before they expired (and which other investors found themselves in the same position). …
For small-time investors in Asia like A’Xiang who bet enthusiastically on oil, though, it has been a reckoning.
She awoke to a text at 6 a.m. from Bank of China informing her that not only had their savings been lost but that she and her boyfriend may actually owe money.
“When we saw the oil price start plunging, we were prepared that our money may be all gone,” she said. They hadn’t understood, she said, what they were getting into. “It didn’t occur to us that we had to pay attention to the overseas futures price and the whole concept of contract rolling.”
In all, there were some 3,700 retail investors in Bank of China’s Crude Oil Treasure fund. Collectively, they lost $85 million.
U.S. oil ETFs can’t go negative—that is, the fund can’t come after its investors if it ends up owing money—but I suppose that is not universally true of retail oil futures products, oops.
The article points to other anomaly-type explanations for last week’s negative prices. (“The trading at settlement mechanism failed,” etc.) But there are certainly also fundamental concerns. Here is “ The Next Chapter of the Oil Crisis: The Industry Shuts Down,” and you don’t shut down an industry because of a temporary financial-markets anomaly:
The best indicator of how the U.S. industry is reacting is the rapid drop in the number of oil rigs in operation, which last week fell to a four-year low. Before the coronavirus crisis hit, oil companies ran about 650 rigs in the U.S. By Friday, more than 40% of them had stopped working, with only 378 left.
“Monday really focused people’s minds that production needs to slow down,” Ben Luckock, co-head of oil trading at commodity merchant Trafigura Group, said. “It’s the smack in the face the market needed to realize this is serious.” …
Before the crisis hit, the world was consuming about 100 million barrels a day. Demand now, however, is somewhere between 65 and 70 million barrels. So, in a worst-case scenario, about a third of global output needs to be shut.
And it’s not just retail investors in goofy financial products who are getting negative prices for oil; actual oil producers are too:
The price shock has been particularly intense in the physical market: producers of crude streams such as South Texas Sour and Eastern Kansas Common had to pay more than $50 a barrel to offload their output last week. ConocoPhillips and shale producer Continental Resources Inc. have all announced plans to shut in output. Regulators in Oklahoma voted to allow oil drillers to shut wells without losing leases; New Mexico made a similar decision.
And while June oil futures prices are still positive and normal-ish, options prices are a little weird. Bloomberg tells me that you can buy a June WTI put option struck at $1 for $1.46. 2 That is an unusual price! The put option gives you the option to sell oil, at expiration, for $1. Ordinarily the most you would pay for that is a little less than $1. The most you’d ordinarily get back on your option is $1, which you’d get at expiration if oil prices were zero. Today you have to pay $1.46. The only way you can make money is if oil prices are negative at expiration. There is trading in this contract. There’s even more trading in the $0.50 strike contract (ask price of around $1.20), an even purer bet that oil is going below zero. 3 It would be strange if, next month, the oil market is again unable to digest the futures expiration, and prices again go negative. But stranger things have happened, and people are getting ready for it.