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Monday, April 20, 2020

Negative Oil (Futures) Prices!

As somebody (I forgot who) noted on Twitter, this crisis has obliterated yet another standard chart: that of the front month West Texas Intermediate futures price, which went negative. For people who are not familiar with the strangeness of financial markets, this may be quite puzzling. For such readers, this does not mean that you will be paid to fill up your car. Rather, it probably just means that one or more funds (using the immortal phrasing of Big Jim and Billy Sol) "blowed up real good."

UPDATE 2020-04-21: The collapse in oil futures prices has continued, and widened. My tone here was perhaps too complacent. It looks like production needs to get slashed pretty quickly, and/or people need to go for drives to get their mind off things. That said, this may still be a continuation of the meltdown of financial commodity players. 

There was a squeeze in the May futures contract, and the unfortunate traders who were long were unable to take delivery. As such, they are forced to sell at whatever price the shorts demanded. If financial market regulation was taken seriously, this probably should have been shut down and an looked into. However, beyond the funds who were victimised, the effects of these negative prices are still limited. The June contract price is still positive, but various sludges masquerading as crude in oil in Canada are negative.

There will be increasing pressure to shut down production -- an expensive process -- but it remains to be determined whether this fiasco will repeat next month. [Narrator voice: it has started already...] As a consumer, crude needs to be refined, and the refining and distribution costs (as well as taxes in places like Quebec) will mean that the effect on gasoline pump prices is limited.

The main lesson to be taken away is for financial speculators. If you are incapable of taking delivery of a futures contract, you should be asking yourself exactly why you are trading the product.* One of the standard trade strategies I saw in sell side research back in the day was hedging breakeven trades with oil futures. Although that looked cute, there was no way to deal with delivery, so I didn't pay much attention. Thanks to modern technology, it is possible to pretend that you are a hedge fund trading futures at home. However, just because a thing is possible, it does not mean that it is a good idea.

Footnote:

* This is perhaps too strong a wording. Entities trading physical markets often use futures in products that they do not actually trade as cross-hedges, and they have no capacity to take delivery. However, if they are involved in the physical markets should be aware of delivery supply/demand situation, and be better able to judge squeeze risk.

(c) 2020 Brian Romanchuk

2 comments:

  1. "various sludges masquerading as crude": hilarious!

    FYI: the retail price of gasoline just dropped to 70.9 cents/l in Gatineau. As a border town the provincial tax is set at the Ontario level.

    ReplyDelete
  2. Admiring the time and effort you put into your blog and detailed information you offer!.. gis midstream

    ReplyDelete

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