On Negative Oil and Futures Prices

“Whoever controls oil controls much more than oil” said John McCain in 2008.  And he was right.  That statement is almost always right.  Except for a brief period last month.

But first, a quick primer on spot oil prices and oil futures, and the difference between the two.  

When we see oil prices in the headlines, they are usually referring to the price of a nearby futures contract for either West Texas Intermediate (WTI) or Brent crude.  Both of these are “light, sweet” crudes (WTI has slightly less sulfur, so is slightly sweeter, and lower API gravity, so is slightly lighter) and these two have evolved as a proxy for the hundreds of other grades and types of crudes produced around the world; even heavier, more sour grades.  

Like Darwin’s finches, as our tectonic plates drifted too and fro over many millennia, each of our crudes developed slightly different consistencies, and they have different names too.  Some of us in the U.S. may have also heard of “Alaska North Slope” or “Light Louisiana Sweet” or even “Mars Sour”.  In Mexico,there is “Isthmus”, in Venezuela there is “Tia Juana Light”, and nearby in Ecuador, there is “Oriente”.  In West Africa,there is “Nigerian Bonny Light”; while 500 miles to the north in Algeria there is “Saharan Blend”, and 2,000 miles to the east there is “Iran Heavy”.

OPEC’s reference prices, for example, are a mix of a few of these above (and many others), but broadly, people in the world will quote WTI or Brent when they discuss where oil prices are.

But that’s pretty simple stuff.  The less simple stuff is that there are spot barrels, forward barrels, and futures contracts; and they can be very, very different.   

The spot barrel is the oil you can buy right now in the cash market for (almost) immediate delivery. Forward barrels are similar cash market transactions where you contract today for delivery of oil at some point in the future. The futures market is simply a marketplace reflecting (in some cases influencing) where these forward prices are being transacted. These futures markets for Brent and WTI are so liquid (oil trades like water…) and well established that producers and consumers (and speculators)will refer to one or the other when they are pricing other crudes.  LLS (the Light Louisiana Sweet crude mentioned above) may trade at a discount or premium to WTI, but more often is contracted in a relationship to Brent (because Brent is imported into the US Gulf Coast).  

So these futures prices bounce around, reflecting expected forward supply and demand for WTI and Brent.  Meanwhile, the price of other crudes will also bounce around, not only reflecting global supply and demand for WTI and Brent, but idiosyncratic features to that particular crude (e.g. its location, relative sulfur content, density/API gravity, proximity to shipping channels, pipelines, refineries, etc.).  

With the futures market specifically, there is the “first nearby” delivery month, the “second nearby” and so on.  It is somewhat active 12, or even 24 months out, but the real action is in the nearby months. There are futures contracts expiring each month that are approximating where cash transactions will take place in the month of delivery.  If it is early January, there will be a contract expiring in late January for delivery in February.  This is the Feb contract.  There is a March contract that also trades, an April contract, and so on.

And this is where it gets fuzzy for people.

You can’t blame them, but many observers (or even participants) think that the oil futures market is indicating where Mr. Market expects oil prices to be in the future. That isn’t what it does.

Futures prices simply indicate what demand is today for delivery of crude in various periods down the road.  This gives rise to the month-to-month spread in oil futures prices.  The February, March, and April futures prices noted above are usually different.

Moreover, calendar oil spreads (e.g. the Feb-to-March or the March-to-April) are typically counter intuitive.  When crude prices are in the normal “backwardation” out month futures prices are lower than the nearby month.  This is because people want oil now.  They don’t want to wait a month, but they would rather wait a month than two months, and they would rather wait two months than three.  In other words, when futures prices for the out months are lower than they are today, it doesn’t mean that oil traders expect spot oil prices to fall.  In fact, it often means the opposite.  

Similarly, if oil markets are in severe contango (a forward month “carry”, where futures prices are higher than spot prices), this does not mean that the market expects oil prices to necessarily rise in the future. It rather is simply reflecting a depressed appetite to own the spot barrel.  

We saw this go to a previously unimagined extreme last month when pipeline and storage capacity was exhausted, refiners were shut down, and there was literally no demand for the nearby barrel.  A steep contango is often indicative of a very weak demand (or strong supply) environment.

On April 20, there was so little appetite for immediate delivery of crude oil those owning May futures couldn’t find any buyers anywhere close to the previous night’s close of $18.27. Some of the holders of that nearby contract which was expiring that next day (April 21) didn’t want - or didn’t have the capability - to take delivery of WTI in Cushing, Oklahoma, so they needed to sell.  But they couldn’t offload their barrels at fire sale prices of $15, or even $10, or even $5/bbl.  

In fact, they couldn’t even give it away for free. They couldn’t sell their oil at zero.

For a brief moment that Monday afternoon, people that owned the May 2020 futures contract had to pay $40 for someone to take it off their severely bloodied hands.[1]  And they did.

There are already many articles describing these events, written by folks that know a lot more about oil and oil markets than we do. But there are two key takeaways that we all should use as our base case for how to think about oil.

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         1)      It is difficult, if not impossible, to consistently predict where oil prices will go tomorrow,and

         2)      When oil futures are in contango, it is usually associated with periods of current weak demand; and when they are backward, it is a reflection of current strong demand.

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Profiting or Suffering from Oil Contango

A very popular ETF on the Street (and in China, it turns out) is the USO.  Up until this negative oil price phenomenon it was constructed to be long the nearby futures contract, rolling to the second nearby two weeks before expiration[2].  When the nearby then expired, the second nearby became “nearby” and the whole rolling process started again the following month.

With that, here is something that at least some USO holders may not be considering.  If demand for crude is weak, as the nearby futures contract rolls off, then over the next four weeks that the new nearby has before it expires, it often drifts back down to where the old nearby expired the previous month. It drifts back down to where people wanted to transact for immediate delivery.  On the simplest of descriptions, it often sinks back down to the spot price.  

So, with this, spot oil prices can theoretically stand relatively still for three, or six, or even twelve months straight, and holders of USOs will suffer the contango each month.  The holders of long USOs can lose a lot of money even if spot crude prices don’t fall. In fact, spot crude prices can even rise a little, but they can still lose money because of the month-to-month spreads.

Of course, something can shake crude out of its doldrums and the futures can flip back around to backwardation.  This would likely accompany higher crude prices all the way out the futures strip, with the strongest moves in the nearby, and the weakest moves in the out months.  Thus, when the crude market is in severe backwardation, the USO holder can benefit if spot oil prices don’t move.  

The USO holder, in the backwardation scenario, makes the spread.  As the ETF rolls its long exposure to the next nearby, it is buying at a cheaper price.  If spot oil prices stay where they are throughout the following month, the new nearby will rise to the spot.  It is then a bit of a free lunch for the USO holder.

So whether it is a free lunch or a very expensive, terrible tasting, lunch, depends on whether or not crude is in backwardation or contango.

This of course works the other way around for those that are short the USOs, or are long “short oil” ETFs such as the SCO.[3] If you are short oil when the market is in backwardation, you are suffering the spread as the ETF manager rolls short exposure forward, establishing sales at lower prices.  If spot oil prices fall down to where you got short, then great, you break even, and if they fall further, you win.  But if they stay where they are, you lose.  

And if you are short oil futures when oil prices are in contango, if the spot price stays where it is today, you win.

So, my advice on these long or short oil ETFs:  If you think you are just betting on (or hedging against) the spot crude price moving up or down, think again.