Futures oil contract trading is generally done by two different groups, speculators and commercial hedgers.
Speculators are essentially taking a position on where oil will be at a future time. If they think it will go higher, they will buy an oil contract to profit from what they expect, a higher price. If they believe that oil will be lower, they will sell (short) oil contracts to profit from the decline they expect.
Commercial hedgers are a different breed. They are hedging positions they have as part of their business. For example, an oil producer knows that he is going to produce x barrels of oil in a given future month. He likes the current price of that future month’s contract and so sells some oil contracts to hedge his production, essentially locking in the money he will receive for that oil. On the other hand, a commercial airline may hedge a future oil purchase for its planes by buying oil in a futures contract and locking in the price it will pay.
Because of the lockdown, the demand for oil in the short term has collapsed. Storage facilities, for the most part, are filled with oil; there is nowhere to put it. Airlines have no incentive to take delivery. and speculators have no storage facilities at which to lay off their long positions. Bottom line: there is absolutely no place to put the oil that will be delivered on the May contract, which closes tomorrow.
The only alternative is to buy out the sellers on the opposite side of the contracts. If they are hedgers producing oil, they have storage in the sense that their production is stored somewhere now. But here is the kicker: the hedgers have no incentive to be bought out of their contracts at positive levels under the current circumstances.
Below is the trading in the May oil futures contract since the start of the year, when it first became a high-volume active contract, up until just before the time the contract fell into negative territory yesterday by $37.63 a barrel, or down 292.66 percent on the day.
As can be seen, a lot of trading occurred around $25 per barrel and then earlier at $50 a barrel.
So if a hedger sold his oil in the May futures market at $25 per barrel, he has no incentive to allow the contract to be bought from him unless the buyer is willing to pay him more than the $25 per barrel he received.
The buyer is trapped. Normally, with plenty of oil storage, this wouldn’t occur, because there would be plenty of bidders for the oil who would be willing to put it in storage. But with storage facilities filled, there is nowhere to put the oil. It has to stay where it is, with the hedger who first hedged his production. But since he can’t sell his production elsewhere because of filled storage facilities, the hedger is not going to allow his contract in effect to get canceled unless he gets more than what he would receive for the oil based on the price he sold it at in the May futures market. That’s why so much oil changed hands yesterday in negative territory, especially in the –$35 range. That’s $10 per barrel roughly above where a lot of hedgers likely hedged.
With all the storage facilities filled, it would be a nightmare for a buyer to actually end up being forced to take delivery. He would face enormous storage penalties. His only option is to buy the contract back from the hedger, who as we can see has no incentive to settle the contract anywhere near positive territory. Thus, the buyer has to pay big time to get rid of his oil. That is, incentivize the original seller to keep his oil. A 50 percent incentive above the original hedge price appears to be the price.
I want to emphasize that this is a short-term phenomenon, with the economy locked down and easily accessible storage filled. Over time, more storage will come online and once the economy is opened up again, the backup in oil will drain. Indeed, at present the market is in contango, an unusual situation in which the farther a contract is in the future, the higher the price is for oil.
The current price for the August contract is a positive $29.20 per barrel. The March 2021 contract is trading at a positive $34.59 per barrel. That is, no one expects producers to be producing oil at a negative price. This is not what is going on currently. There is a sudden bottleneck at storage facilities because of the lockdown, with delivery about to be scheduled to May futures contract holders who have no place to put the oil.
Finally, the real takeaway here is that oil producers are not producing oil they can’t sell—they would stop that in a minute. Rather, speculators are being faced with the delivery of oil that they have no capacity to store and thus must pay to get the delivery obligation removed at a time when there are few that can handle that obligation.
This article originally appeared at EconomicPolicyJournal.com.
