Negative Oil Prices Are A Long Squeeze, Not A Crisis

At one point yesterday, the May WTI contract was ‘selling’ for negative $30 or more, and the sound of jaws dropping probably hit 3 on the Richter scale. As of 5 a.m. today the contract was trading for about negative $2/barrel, up $36/barrel, perhaps the largest one-day increase ever. Except that it’s largely unreal.

My theory is this: there were a number outstanding long contracts and today’s expiration of the May contract meant that those holding them either had to take delivery or sell the equivalent amount of oil. With few buyers, selling the contract is difficult to impossible and many trading on the futures market have no ability to take delivery of the contract. Available storage in Cushing doesn’t help if you’re a day trader in New Jersey.

And traders knew that there would be some out there unloading contracts at any price, and so they sold the contract, driving prices down but giving them bigger profits as those long in the market were forced to sell at ever-lower prices. So, the price on the futures contract spirals down.

(There was an excellent 1950s show “The Many Loves of Dobie Gillis” where the star, Dobie, to impress a girl in his business class, follows her trading strategy on the egg market but doesn’t realize that he has to take delivery when the contract closes. When the eggs show up at his father’s store, hilarity ensues as they say, but the local university has a contract to make flu vaccines and needs the eggs, so a happy ending that oil traders could only wish for now.)

The current situation is very reminiscent of the early 1990s Metallgesellschaft’s hedging debacle, where the company’s trading arm offered guaranteed oil product prices by hedging in the futures market, rolling over the contract every month. This worked well when the market was in backwardation, meaning the future price was lower than the current price. But the price moved into contango and the company was exposed to large losses. (See the article cited below.) This is an excellent example of how lengthy experience is valuable in interpreting developments, BTW.

So, it was forced to close out its position, which was very large, and other traders recognized this and sold the contract, putting more pressure on Metallgesellschaft to sell at ever lower prices in a self-reinforcing spiral. The company had nearly $2 billion in losses and the price for the futures contract plummeted, but briefly. The physical market was mostly unaffected.

The same is likely to happen here, although it comes with the background of a global pandemic. By Wednesday, the price is likely to be at least $20, and possibly $25. The oil industry faces a serious challenge, but this bizarre occurrence does not reflect the reality of the physical market. Storage is filling but still available and the crisis is on the paper market, not the ‘real’ world.

SsrnMaturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle