Crude Oil Is an Example of Why You Should Stay Away From Commodities Trading

by Dilip Shaw Date: May 28, 2020

in Newsletters

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If you do not know on Monday, 20-Apr-20, in the US, Crude Oil FUTURES fell below $0 a barrel to -$40. Yes MINUS $40. So basically the sellers of Crude Oil futures had to become buyers (closing the trades), to get delivery of Crude Oil. So the buyers were actually paying the sellers, to get their hands off the stock they have to keep in their stores, in the US.

What do ‘negative prices’ mean?

You see, oil is produced and kept in stores. This involves cost. Oil producers and sellers make a profit only when it is sold at a higher level than all costs, including such as producing, transporting, storing and labour. Unfortunately, there are no buyers in such a market when the US went on a complete lock-down. So even storing was getting difficult and costly.

If they were making a profit, even very small, the price would have not gone below ZERO, but even storing oil is a loss – so the price of futures went below zero. In other words – negative returns for future traders and HUGE LOSS for buyers (both futures and crude oil buyers).

Oil producers in the US were paying buyers to take the barrels of oil off their hands because storage facilities were full. They could not keep the oil anymore.

At the market’s lowest point on Monday, 20-Apr-20, an oil company might have paid about $40 for every barrel of oil someone was willing to take.

Understanding the Last Trading Day in the US

The last trading day is the day before a derivative expires. On the expiry date, the derivative is no longer trade-able (in cash) and the settlement process begins.

What is the Settlement Process

A future seller will have to take physical delivery of the stock/commodity equal to the lot size traded. If he sold a future for 100 and bought it at 60, then he gets the physical delivery of the stock/commodity at 60 which he will have to pay to the seller to close the contract. But he sold for 100, so once the prices rise he can always sell that at a higher price and not close the contract – he then profits if the settlement price is more than the buy price.

90% of the future contacts are speculative trades and so are settled in cash one day before the expiry.

Assume the expiration date on an options contract is Friday, March 22. The last trading is Thursday, March 21.

Unlike in India, in the US Futures can be cash-settled only one day prior to the expiry day. If the contract is taken to the expiry day, then are NO cash-settlements in the US. A seller of the future, to close the trade, will have to buy the product equal to the lot size traded. Similarly, a buyer of the Future will have to give away the stock from their Demat account to the buyer of the future to close the trade.

What is the Solution to Overcome This Issue?

To overcome this issue, traders in the US cancel out their trades by purchasing a covering position. This is what they will do. They will buy next month contract to cancel out an earlier sale (covering current month future short), or selling a next month future contract to liquidate an earlier purchase (covering long future).

The last trading day is the final day that a futures contract can be traded or closed out. Any contracts outstanding at the end of the last day trading day must be settled by delivery of the underlying physical asset, exchange of financial instruments, or by agreeing to a monetary settlement. The specific agreements covering these potential outcomes are contained in the futures contract specifications and vary between securities.

When the Sellers of Crude Oil were in Huge Profit so What is the Problem?

Remember that on expiry day a seller becomes a buyer. As a buyer, he/she would need to factor in the cost of transporting oil from the well to a shipping port, or a storage facility, where it may need to be held for up to six months, at significant cost. Or, if they are delivered oil already lying in a storage facility then they will have to pay the rent for the storage facility to the owners until the market for crude oil picks up so that they can sell and make a profit.

On top of that, they would also need to bet that oil prices will rise later this year to make a return on the “investment”. No oil company wants to “sell” their crude at a loss, so many producers are likely to shut their wells until the market recovers.

If the crude oil owner did not enter a future trade his loss is the production and storage of the oil until the demand for crude oil picks up. Add to this the interest rate loss equivalent to liquid funds in the US. When they finally start selling crude oil, to make a profit they will have to keep all these expenses in mind before finalizing the price.

More information on Crude Oil Future Trading in US

Most of the oil is traded via Futures Contracts, not Options. There is a Spot Price as well, which is taken into account while arriving at the “theoretical futures price”.

There are two main Futures Contracts (remember this is simplified) – The WTI (West Texas Intermediate – also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light crude oil because of its relatively low density, and sweet because of its low sulfur content), and the Brent – The most popular traded grades are Brent North Sea Crude (commonly known as Brent Crude).

West Texas Intermediate (WTI) refers to the Oil from North America, while Brent refers to oil from Middle-east, Europe and Russia.

There are a million variants, but we will omit those for the moment since they complicate the discussion without really adding any clarity.

The “Oil Price” that went negative was the settlement prices for the May 2020 Delivery Contract (ONLY THAT ONE) – This is important!!!

Some more complexity – There are two forms of settlements for Crude Oil Futures Contracts (and for most commodities), viz Net Settlement and Physical Delivery.

The net settlement allows the buyers of the contracts to settle the financial difference between the buying price and the settlement price – this is cash settlement which is very common in India. In a cash settlement, only the final profit and loss is exchanged between the sellers and buyers.

If a buyer of a Futures Contract doesn’t opt for net settlement on or before the “Notice Date”, which passed last week for the May 2020 Delivery, then they are assumed to be taking physical delivery of the underlying quantity of Crude Oil. This is also important. Since October 2019, in India too, ALL stocks are physically settled if they are NOT closed on the expiry day. Source

Read: All stock derivatives will be physically settled from October 2019 series.

And that “technical problem” pushing the settlement price of May 2020 Delivery Contracts to become negative. There is a buyer, or many buyers, who were stuck with a physical delivery option that they can’t actually use (please read above to know why they cannot use oil if they got them physically). They knew this problem, so they could not take physical delivery of the underlying crude oil they got, (because they closed their Future short). They could not take physical delivery of crude oil because they did not have the storage capacity to store the oil.

But then the good news was the very low rather negative price of oil. This got some buyers (mostly oil refiners, or a storage facility or a driller) to take the delivery off their hands by PAYING them to buy the oil that’s ready for May 2020 delivery.

This has NEVER happened before in the history of Crude Oil Futures trading. This was a Very Unique Situation.

On that day the June delivery West Texas Intermediate (WTI) Futures was still trading in positive territory at $20+/ BBL. And the Brent Futures for June 2020 was trading at $25+/ BBL.

Did this have any implications?

Yes, it did. It means that the US Crude Oil producers were in a serious problem and were facing a glut. They knew that if they don’t stop drilling, they will have to give the oil away for free, and/or pay people to buy that oil.

Another Painful Point for Crude Oil Sellers

This oil is not trash/rubbish and therefore can not be dumped or disposed off in the sea or anywhere else since that will cause an environmental disaster and result in billions of dollars of penalty (Exxon Valdez Oil Spill, Deepwater Horizon oil spill, etc.)

Was There Any Other Problem For Crude Oil Sellers or This is The End?

Yes, there was another problem. The problem was drilling cannot be stopped as the cost of drilling is high & cannot be kept idle. If kept idle for long all the machinery to drill will need repairs involving millions of dollars.

I hope you now understand what went wrong with Crude Oil Future traders on Monday, 20-Apr-20, in the US. If you also traded on that day and if you were a Crude Oil Future Buyer in India – what happened to your trade. Please write in the comments section below.

This is the reason one should not trade in commodities, as the prices are unstable, very volatile and absolutely unpredictable which may results in huge losses for the traders.

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About the author: Dilip Shaw I started trading stock markets since 2007. However my first 3 years were losses. Then I dedicated almost 1 year on studying, researching, paper trading options and learned a lot in that time. Since 2011 I am trading Nifty options profitably. Call me if you need any help trading options on 9051143004.