An Arbitrageur’s View of Negative Oil Prices
Until this week, negative energy prices were known to only occur in Germany’s renewables-fueled electricity market. Anytime a breeze blows during the summer while the sun is shining, so much excess electricity is generated that German consumers are paid for burning electricity. The underlying cause is the lack of technology for electricity storage on a large scale.
Storage is easier to find for oil: when too much of it is produced, then the excess ends up in giant storage tanks. Sometimes, even oil tankers are chartered for storage. But, what’s unusual now is the fact that as a result of lower oil consumption due to the corona crisis, oil tanks are filling up almost everywhere. JP Morgan estimated at the beginning of April that all available storage capacities on land would be fully utilized by the end of May. In June, the last tanker on the high seas might be full to the brim.
Regional bottlenecks may occur even earlier, such as these days in the town of Cushing, Oklahoma. With a population of 7,800, it does not have the vibe of a global oil trading hub. But on the first day of every month, Cushing is the physical delivery location for crude oil futures traded on the New York commodities exchange known as NYMEX. Delivery options are somewhat limited: only tanks and pipelines managed by Enterprise or Enbridge qualify.
Most futures contracts are closed out before the delivery date and no physical oil ever changes hands. The futures price typically serves market participants as a reference price for other oil transactions that they index to it. And for anyone who actually accepts physical oil delivery in Cushing, they have to store it somewhere, and that storage capacity is currently in short supply. In fact, the limited facilities in Cushing or those that are easily accessible from Cushing are full. As a result, many oil traders were forced to sell their futures contracts for May 1st delivery before the last trading day on April 21st. Due to the storage problems, few buyers were able to step in. With an excess of sellers over buyers, the price not only went to zero, but collapsed into negative territory to a low of -$40.32.
Remarkably, the prices of futures for June 1st delivery or for the following months were not as significantly affected by this extraordinary set of circumstances. Crude oil for delivery on June 1 held above $20, and the subsequent delivery months were correspondingly higher in price.
Under normal market conditions, arbitrageurs ensure the integrity of futures prices. Hence, prices differ from one month to another mainly by storage costs of under one to two dollars per barrel per month. If prices diverge by more than that, arbitrageurs could buy oil futures with a delivery date of May 1st, sell at the same time futures for delivery on June 1st and store it temporarily for a month. If prices differ by more than the storage costs the arbitrageurs can make risk-free profits. For example, with negative futures prices of -$40 for the May 1st delivery and positive prices of $20 for June 1st delivery, an astronomical profit of $59 could be generated without much risk. But only in theory, because this strategy won't work without storage capacities. And if the arbitrage strategy cannot be implemented, then prices can diverge to non-economic levels.
Instead of arbitrageurs making profits in oil, bargain hunters ended up facing huge losses. Anyone who bought an oil future for $17 a barrel on Monday morning had to pay $38 in the evening to get rid of it. A loss of 324 percent in less than a day.
Some other circumstantial evidence suggests that the negative price was not real but merely a technical phenomenon. Brent oil futures did not face a similar move in the price of the front month. The important difference between Brent and WTI futures are that Brent futures are cash settled rather than settled through physical delivery of oil. Moreover, the oil underlying Brent is traded in Rotterdam, a maritime port that in addition to having pipeline access is also reached by oil tankers. In contrast, the oil in Cushing is landlocked so that transportation is limited by pipeline capacity.
In theory, oil futures contracts that allow for physical delivery should produce price discovery that is closer to the actual underlying; however, as we see all too often, theory and practice don’t always align. It is up to the NYMEX to modify the contract specifications in a way to minimize delivery problems in the future.
Physical delivery always gives rise to opportunities for mispricing, whether by accident as in the case of this week’s WTI oil price behavior, or by deliberate market manipulation. One of the authors used to trade bonds in Europe and often observed games being played with bonds deliverable into European government bond futures contracts. This is much less of a problem for the U.S. Treasury futures contract due to the much larger size of U.S. government debt compared to that of individual European countries. The parallels between delivery problems in bond futures and oil suggest that it is time for a complete overhaul of physically settled commodities futures – what happened in oil this week could perhaps happen pork bellies or other commodities in the future.
We will see during the next few days who shouldered the losses on the NYMEX WTI futures that went negative in price. The big ETFs and most professional oil investors usually roll their exposures weeks before the expiration of the futures contracts. They are well aware of the risks of waiting to the last minute. Therefore, the parties remaining on Monday were probably opportunistic investors that dabble in oil only occasionally and saw $20 as a great entry point for the long run, without realizing the roll problems that can be experienced in the physical settlement of futures contracts. Given the amount of leverage that can be employed with futures, some speculators are likely to have suffered devastating losses.
Thomas Kirchner, CFA has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016).
Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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Originally published on http://www.camelotportfolios.com/commentaries