In today's newsletter, we explain how oil breached the charts and traded at sub zero levels
Note: This is another 3+ minute read. So please do bear with us :)
It’s December 21st, 2019
You make an agreement with a counterparty — an oil producer from Texas.
The premise is simple. You pay him $40 today for a barrel of oil. He is supposed to supply you the said barrel in the month of May (2020).
You title this contract note — Oil Futures and you sign off on the deal.
But you are not looking to buy the (physical) oil off of him. Because if you do, you'll have to accept delivery from the oil producer and take those barrels home. That would be silly.
Instead, you have a very different idea.
Between now and May, you figure oil prices will go on a spectacular rally. Maybe even hit $70 for all you know. And once the price is attractive enough, a lot more people are going to want to buy this contract off of you. Perhaps a refiner in South Carolina who is looking to buy it at a discount to the current market price?
Because if everything works out, the refiner will walk away with the oil contracts. You walk away with a tidy profit. This is a win-win for all parties.
However, you’ll have to get rid of the contract note before April 20th. The New York Mercantile Exchange (NYMEX) that facilitates these transactions have set an expiry date of sorts. So you can’t trade past this due date. However, you are not too worried, because you think you can sell it in February tops, no problem
But there is a catch. These contract notes will only be worth a fortune if oil prices go on that rally you expect. If they don't, your contract notes won’t be worth all that much.
And you begin suspecting that might be the case as soon as February draws to a close.
The Markets are flooded
On March 8th, news channels start reporting how talks between OPEC (read Saudi Arabia) and Russia have finally collapsed, possibly precipitating a price war that could push oil down to as much as $20 a barrel.
Almost, instantly, every major oil-producing nation goes on the offensive. They start ramping up production like there is no tomorrow. Obviously, this also means they will have to find avenues to store all this excess supply. Unfortunately, the reserves are filling at a pace that belies all rational expectations. You turn off the TV and go to bed.
“All will be fine”, — you tell yourself.
A month passes. It’s now April 13th, 2020
Amidst the doom and gloom surrounding the oil markets, a tweet from President Donald Trump offers some respite. He assures everyone that a deal is now in place — that he’s convinced, all major oil-producing nations will now scale back production and help prop up oil prices.
You want to feel hopeful. But you can’t. Because you know something, others don’t. The second-order effects are already playing out in the open and you can’t stop it now.
Trouble at the Refinery
Now bear in mind, crude oil isn’t the end product. It’s an intermediary that requires additional refining. You don’t get petrol or kerosene, right off the bat. You need to pump crude through a processing facility hoping to turn it into a consumable product. So unless refiners have the capacity to process all this excess oil, you can’t put your crude to good use.
And at this point —Many parts of the US are already under lockdown. Demand for oil has plummeted. The country is now at a standstill.
So if the refiners can’t get this oil on to the motor trucks and the industries that power the nation, they’ll have to start refusing all supply from crude oil producers. Some players are even considering invoking an obscure clause in the contracts — Force Majeure or an act of god, referring to the unforeseeable circumstances that prevent them from fulfilling their end of the contract. All in an attempt to shun all the excess oil making its way into their pipelines and processing facilities
And finally, it dawns on you. The foregone conclusion you've failed to acknowledge.
Nobody in this country wants oil right now. The producers (who dig the oil) don’t want it. The refiners won’t touch it. And the consumers have no need for it.
And that also means nobody wants your precious future contracts either. Even if you are selling it at a steep discount. So with this thought in mind, you start considering the possibility of accepting the actual commodity in its full physical glory come April 20 — the expiry date.
You start mapping the logistics trying to see if you could actually accept delivery, store it for a few months and sell it for a premium later.
You start thinking about seeing this transaction through.
It’s now April 20th, 8:00 AM. And the Settlement Dilemma kicks in
How to accept delivery?
Most of the crude oil (traded at New York Mercantile Exchange) ends up at a delivery point in Cushing, Oklahoma. Meaning if you are party to the contract, the transaction is settled at a warehouse sometime between May 1st and May 31st.
Now, once you’re at the facility, you have a choice — either use Cushing’s own storage tankers (by paying a periodic fee) and park your oil right there or remove the commodity from the warehouse and transport it elsewhere.
But removing oil isn’t as easy as you think. For starters, we aren’t talking about 2 or 3 barrels of oil. These future contracts have a specified lot size of 1000 barrels. Meaning the moment you entered into that transaction in December, you promised you’d buy at least 1,000 barrels.
Now, where on earth would you plonk 1000 barrels of oil if you weren’t prepared for this eventuality. You can’t dump it in your backyard. I mean, think about what would happen if you accidentally set it on fire and burn half the neighbourhood. That right there is a no go and in any case, you need a certified storage space to put this stuff.
So perhaps your best option is to simply pay the folks at Cushing and store the oil for a month during which time you could perhaps try and sell the oil to someone else.
But unfortunately, Cushing is witnessing a demand surge — the likes of which they’ve never seen before. Two months ago, they were barely operating at 50% capacity. On April 10th, they were at 70%. And based on analyst estimates, Cushing is now hurling towards the 80% mark.
And as soon as you start getting close to full capacity, you start seeing all kinds of problems.
Think of it this way. Storage units like the one at Cushing follow a dynamic pricing model. As you start approaching peak capacity, prices start rising disproportionately and when you inch towards the 100% mark, prices reach such exorbitant levels that you’d start thinking about building your own storage facility as opposed to using the one at Cushing.
So what do you do now?
Well, your next best option is to transport this elsewhere. And a popular choice these days are large offshore containers floating somewhere on the Coast of Africa. But here’s the thing — people have been betting on a recovery in prices for a while now. And they’ve been hoarding cheap oil in the hope of selling it at a premium by the end of this year. And they’ve rented most of these supertankers already. So you’re not getting space here. Absolutely no chance!!!
It’s April 20th, 2:00 PM now, 180 minutes to Expiry.
You take a look at the charts and your oil futures are now dangerously flirting at levels close to $0. You cannot believe what you are seeing. Your contract is practically worthless now and if you take delivery, you’ll probably end up spending more money on storage. You are getting desperate and you start thinking about drastic measures.
What if you simply refuse to accept the oil? Let it rot in Oklahoma. Who cares? At least you won’t have to pay for the transportation & storage, right?
You can’t do that. Because you are legally obligated to fulfill your end of the bargain. And the stock exchange that facilitated the transaction will make sure you do. If you don’t pay up the storage costs, they’ll take you to court.
Its 2:08 PM, 172 minutes to expiry
You glance at your screen once again and in the blink of an eye, oil future prices breach $0 and it’s now trading at negative levels. A historic moment, you think to yourself. But you can’t help but agonise over the unfortunate circumstances right now. How on earth did you end up on the wrong side of one of the greatest trade ever?
You shake your head and decide to accept your fate. You must get rid of these contracts right now. Beyond this point, you’ll have to pay people to get them interested.
Its 2:14 PM, 166 minutes to expiry
You finally punch in the order and sell it at $5 a barrel. The only catch here is that you’ll be paying the buyer $5.
But you’ve gotten off easy. Because unbeknownst to you, hundreds and thousands of oil traders across the US are now scrambling to sell their contracts as well. They are being told there’s no storage available. And if they accept delivery, they can’t keep it at Cushing anymore. It has to leave the warehousing facility. But where will they take thousands of barrels of oil? The world is running out of storage space. This is madness, and as more people start seeing prices tumble, collective hysteria kicks in.
Nobody wants to buy. Everybody wants to sell.
Prices breach -$8
Prices breach -$15
Prices breach -$30
The "future" has now converged to the present.
Oil just hit -$37
As Vladimir Lenin once said — "There are decades where nothing happens, and there are weeks where decades happen"