Tuesday, April 21, 2020

This is Why the May Oil Contract Price Went Negative on Monday


Ok, I am going to explain this in a simple narrative format so some of the complex technicalities won't be here but the main point will be made.

Futures oil contract trading is generally done by two different groups, speculators and commercial hedgers.

Speculators are essentially taking a position on where oil will be at a future time. If they think it will go higher, they will buy an oil contract(s) to profit from what they expect, a higher price. If they believe oil will be lower, they will sell (short) oil contract(s) to profit from the decline they expect.

Commercial hedgers are a different breed. They are hedging positions they have as part of their business. For example, an oil producer knows that he is going to produce X barrels of oil in a given future month. He likes the current price of that future month's contract and so sells some oil contracts to hedge his production, essentially locking in the money he will receive for that oil.

On the other hand, a commercial airline may hedge a future oil purchase for their planes by buying oil in a futures contract and locking in the price it will pay.

Because of the lockdown, the demand for oil in the short-term has collapsed, storage facilities, for the most part, are filled with oil, there is nowhere to put it.

Airlines have no incentive to take delivery and speculators have no storage facilities at which to lay off their long positions.

Bottom line: There is absolutely no place to put the oil that will be delivered on the May contract which closes tomorrow.

The only alternative is to buy out the sellers on the opposite side of the contracts. If they are hedgers producing oil, they have storage in the sense that their production is stored somewhere now, but here is the kicker, the hedgers have no incentive to be bought out of their contracts at positive levels under current circumstances.

Below is the trading in the May oil futures contract since the start of the year, when it first became a high volume active contract, up until just before the time the contract fall yesterday into negative territory by $37.63 a barrel or down 292.66% on the day.




As can be seen, a lot of trading occurred around $25 per barrel and then earlier at $50 a barrel.

So if a hedger sold his oil in the May futures market at $25 per barrel, he has no incentive to allow the contract to be bought from him unless the buyer is willing to pay him more than the $25 per barrel he received.

The buyer is trapped. Normally, with plenty of oil storage, this wouldn't occur because there would be plenty of bidders for the oil who would be willing to put it in storage. But with storage facilities filled, there is nowhere to put the oil, it has to stay where it is with the hedger who first hedged his production. But since he can't sell his production elsewhere because of filled storage facilities, the hedger is not going to allow his contract in effect to get canceled unless he gets more than what he would receive for the oil based on the price he sold in the May futures market. That's why so much oil changed hands yesterday in negative territory, especially in the negative $35 range. That's $10 per barrel roughly above where a lot of hedgers likely hedged.

It would be a nightmare for a buyer to actually end up being forced to take delivery, with all the storage facilities filled. He would face enormous storage penalties.

His only option is to buy the contract back from the hedger, who as we can see has no incentive to settle the contract anywhere near positive territory.

Thus, the buyer has to pay big time to get rid of his oil. That is incentivize the original seller to keep his oil. A 50% incentive above the original hedge price appears to be the price.

I emphasize this is a short-term phenomenon with the economy locked down and easily accessible storage filled. Over time, more storage will come online and once the economy is opened up again, the back up in oil will drain. Indeed, at present, the market is in contango, an unusual situation where the farther out a contract the higher the price is for oil.

The current price for the August contract is a positive  $29.20 per barrel. The March 2021 contract is trading at a positive $34.59 per barrel. That is no one expects producers to be producing oil at a negative price. This is not what is going on currently. It is a sudden bottleneck at storage facilities because of the lockdown with delivery about to be scheduled to May futures contract holders who have no place to put the oil.

Finally, the real take away here is that it is not oil producers, producing oil they can't sell---they would stop that in a minute. It is speculators being faced with the delivery of oil that they have no capacity to store and thus they must pay to get the delivery obligation removed at a time when there are few that can handle that obligation.

-RW







3 comments:

  1. Good exposition. Thanks, Robert

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  2. The closer you get to delivery day, the more accurate the price of the futures contract is. Futures are real price discovery. The fact is there is currently so much oil, there is no where to put it especially at the specific delivery spots. Logistics is an issue with oil. Speculators are good. It is because of them true price discovery happens. The more speculators the better, as it causes liquidity to the market.
    This will happen again next month if demend doesn't pick up or supply drop substantially, or logistics of delivery change.
    The only reason the futures contracts further out are higher right now is there is more time for equilibrium to arrive, and that gets priced in.
    With oil it gets interesting as there are only so many places the oil can get delivered. Taking delivery needs to become more decentralized. These bottlenecks of only being able to take delivery in certain locations and certain piplelines cause storage issues like this, and thus price action like this.

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