'Interesting Times' in Oil Futures

Oil barrels
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“May you live in interesting times” is a saying that is itself somewhat interesting. There is some evidence that the phrase, which is usually said to be an ancient Chinese curse, is neither ancient nor Chinese, but is in actuality relatively modern and western. Still, whatever the origins, the fact is that we live in interesting times right now, and interesting times lead to interesting developments. Yesterday, for example, short-dated WTI crude oil futures contracts dropped into negative territory for the first time in history.

Oil futures

The oil market yesterday was by far the strangest market in anything I have ever witnessed, and I have been involved in financial markets in one capacity or another for nearly forty years. A roughly 300% drop in the price of a physical commodity, taking it well into negative territory, was unthinkable to most people before yesterday. I mean, it must have some value to somebody, right?

Well, as we found out yesterday, not necessarily. If crude oil storage facilities are at maximum capacity, as they are right now, as demand collapses to virtually zero, then producers of crude face a problem. Their excess capacity can’t be stored, but neither can it be disposed of. Simply dumping it isn’t an option. That would lead to unknown levels of ecological disruption and probably business-ending EPA penalties. Paying someone to take it off your hands is, in that scenario, a perfectly sane economic decision.

Even so, the sight of the May WTI futures contract, CLK20, which expires later today, trading at negative $40 was unbelievable. There are other, more technical reasons that it happened too, and potential consequences that many may not have considered.

Futures trading is done on a margin basis, where traders basically leave a deposit with an exchange to cover potential losses on their trade. Once a certain loss level pre-set by the exchange is hit, then traders have to stump up more cash to cover potential future losses or their contracts are automatically sold. In a situation such as we saw yesterday, those usually rare events, known as margin calls, happen to just about every long position. Once the move starts, therefore, it becomes self-fulfilling to some extent.

What that also does, however, is force the exchange to ask for ever increasing margins. That means that many more margin calls are not met, which increases the selling pressure, which increases margins, etc., etc. A true vicious circle. Yesterday’s events were specific to the May contract but could still lead to much higher margin calls in the future, which may result in thin markets and therefore volatility in oil for some time to come.

There is another long-term effect too.

While all that was going on in CLK20, CLM20, the June contract was also falling dramatically. It dropped around twenty percent, but still closed the day at just over $21 a barrel, and contracts further out the curve were higher still. That is a welcome indication of a return to some kind of normalcy before too long, but it creates contango of epic proportions, which has implications for a lot of investors.

Contango is the normal state of affairs in commodity futures, where longer dated contracts trade higher than short ones. There are a few reasons for that, but it is primarily because investors who tie money up for a period of time demand a premium for doing so. In this case though, from -$40 at the short end to +$20 or so at the long, that difference was massive.

That means that those wishing, or in some cases having to “roll over” contracts from one month to the next had to sell at -$40 and buy at $20, an immediate $60 per contract loss. Now it is doubtful that much of any rollovers happened at those levels but the difference between May and June WTI contracts has been huge for some time. That has a big negative impact on crude oil ETFs.

They are normally a popular way of speculating on oil prices for investors who don’t want to can’t use futures. They are designed to reflect oil prices and are generally available with added leverage as well as just a straight 1:1 target relationship. The problem is that that relationship is rarely if ever 1:1, 2:1 or 3:1 as intended. Those funds are constantly rolling over futures contracts, so contango eats into their returns. With contango at these levels, that is massively significant. It means that even if you think yesterday’s collapse was a classic market overreaction, buying an “index tracking” ETF is not the way to play it.

WTI futures at big negative numbers were a one-off, created by oil’s singular properties and a “perfect storm” of oversupply and an unprecedented decimation of demand. It was a unique situation but could still have impacts for a long time to come. Interesting times, indeed!

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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