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What Really Caused the Epic WTI Meltdown?

Copyright © 2021 Energy Intelligence Group

Speculative traders chasing scarce oil storage space to close out expiring paper positions were the main driver behind this week’s historic crash in US benchmark futures trade, according to an Energy Intelligence investigation. To be sure, dire fundamentals -- overflowing storage and pipeline backups -- were part of the problem that saw front-month West Texas Intermediate (WTI) prices plunge into negative territory for the first time. But Energy Intelligence understands that the catalyst involved at least two hedge funds, money managers of high net worth individuals and likely other parties -- all financial traders with speculative positions but without assets -- who were scouring the market for any storage available, desperate to close out long positions. Put simply, they had taken paper positions betting that oil prices would rise. But as contracts came close to expiry, and with buyers scarce, they faced the prospect of being obliged to receive physical oil. No storage was available. Or at least, savvy storage traders had some tank space still tucked away but were holding out to maximize the value of their positions. As WTI dipped below $10 per barrel, the sellers issued orders to “sell at any price” to close out their positions, sources say, but there were no buyers. At the depth of the frenzy, brokers say there was one offer to buy against 95,000 bids to sell. Finally, at a gut-wrenching -$40/bbl, tank owners moved to cover their own short positions and bought the oil, setting the stage for a return to positive prices. The findings challenge reports earlier this week that the United States Oil Fund (USO), an exchange traded fund that allows retail investors to trade in oil futures, led the breathtaking drop. Oil traders have moved this week to mitigate their exposure to a repeat performance with the June WTI contract. But with US storage now filling up, a repeat performance in coming weeks cannot be ruled out. Why did WTI fall into negative territory when global prices did not? The two main global benchmarks, Nymex WTI and ICE Brent futures, can both in theory trade in negative territory. But Nymex crude futures contracts expire into delivery of physical barrels, whereas Brent is financially settled. This means that anyone holding an expiring WTI contract may be obliged to deliver -- or in this case receive -- physical oil at the storage hub at Cushing, Oklahoma. If there is no storage to be leased, this becomes, quite simply, impossible to fulfill. WTI faced specific conditions on Monday as traders chased limited storage. At the start of trading Monday, 108,500 contracts for May WTI delivery were still open. This represented some 108.5 million bbl that could be delivered into Cushing, which only had roughly 20 million bbl of storage available, according to government data (related). On average, some 2 million bbl of expiring WTI futures typically end up getting delivered as physical oil, with all other contracts financially settled. When the May WTI contract expired on Tuesday, 13 million bbl was still open. It is not yet known how much of that will ultimately get delivered. Is that a normal amount of oil marked for delivery at expiration? No. Open interest in the May contract was at the top of its range for the past few years, according to data from Nymex parent CME, making for a messy expiration at the best of times and a total nightmare given the extreme imbalance in supply and demand and rapidly filling inventories. It is customary for the CME to ask all those holding open interest in WTI close to expiration to declare their intentions -- basically asking, “Where will you put all this oil?” This is a phone call that most traders dread, and they will typically take losses earlier in the month to close positions rather than deal with the logistics of delivery. Who was involved and are they still in business? Traders say that the trading activity centered on at least two hedge funds, high net worth individuals and likely other parties. The market is still quiet on their identities. The chairman of the regulatory US Commodity Futures Trading Commission (CFTC) said all margin payments were made and no parties defaulted as a result of Monday’s crash. Interactive Brokers, one of the most popular brokers for smaller, noncommercial traders, did take a hit from the day’s volatility. It says it incurred a provisional $88 million loss after several accounts were margined out -- where losses exceed equity and are automatically closed -- by the swiftly falling prices. Exchanges say they have systems in place to function smoothly with negative prices. But the extreme volatility raises a red flag for exchange shareholders, as such swings are likely to generate defaults sooner or later. CFTC data show banks and hedge funds, as well as smaller traders, buying 50,000 WTI contracts betting on higher prices in the week ended Apr. 14. Some of this would have involved the prompt month of May, although not all of it. At the same time, commercial traders, those with physical assets, had sold more forward oil than at any point in the past two years -- basically making bets that oil would fall in price. Those with storage and the ability to take delivery were more than happy to close out some of these short positions by essentially getting paid to buy futures at minus $40, a masterstroke in trading. Swiss-based trader Trafigura told Bloomberg that it bought some of the negative-priced oil. Did the role of index funds exacerbate the swing down? USO has been blamed for exacerbating the fall in oil prices, as investors poured $1.6 billion into such ETFs -- passive-long financial instruments -- in bets on oil prices rebounding, just as the May WTI contract was headed toward expiration. But the head of USFC, which owns USO, said USO owned no May contracts as of Monday, when prices melted down, having already sold them between Apr. 7-13 under its roll schedule. USO by far owns the most futures of any oil ETF. These products typically have statutes mandating that they roll out of prompt oil contracts well ahead of expiration. There is also a whole ecosystem of financial derivative products including more exotic ETFs and ETNs, which unlike ETFs are unsecured by assets and track an index. These may well have still had a few contracts of May oil, which would have exacerbated the fall in prices as liquidity dried up. What happens now? Monday’s drop was truly historic and rewrites the commodity trading book (OD Apr.21'20). Both CME and ICE have introduced new options on futures with negative strike prices, which is a first for crude but exists already in other financial products. CME and ICE say they have both implemented systems that should allow them to function smoothly in a negative price environment. Will it happen again? Investors took note of the front-month WTI contract’s hazards the very next day. They mostly abandoned the June contract, with some rolling into July. Some 120,000 June contracts were sold on Tuesday and the mass exodus shaved $8 off that contract’s price. This may be enough to stave off another fall into negative territory. The price crash has not dampened investor enthusiasm for betting that oil will rebound as the global economy regains its thirst for oil. Yet so much oil is in storage that fundamentals will continue to weigh on prices for some time. And with the system filling up, chances are growing that another dislocation and sharp price drop could happen again. Ian Stewart and John van Schaik, New York

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