On Monday, just a day before the May contract for West Texas Intermediate crude was due to expire, US oil prices plunged into negative territory for the first time in history. The move broke bank risk desks, as traditional options models assumed zero was as low as prices could go. It also broke exchange traded funds (ETFs) that invest in oil and no doubt a few hedge funds. It was seen by many as nothing more than a rollover issue, as the May contract had become so illiquid, and trading desks had long abandoned it for June. But as soon as the June contract became the ‘front month’ it too tumbled and Brent, the international benchmark, has just slumped to a 21-year low. There is trouble in the oil market that goes well beyond the technical aspects of futures trading.
There has been no let-up for crude prices. Less than a week after Opec secured an historic agreement to reduce global output with the backing of its key ally Russia and the G20, prices of US crude fell below zero as demand forecasts collapsed and the true extent of the coronavirus impact was laid bare. The pressure on the front month contract intensified and May WTI plunged to -$40 at one point as traders were forced to exit positions before the expiry. This was largely because of a lack of storage capacity combined with virtually no physical demand due to the Covid-19 lockdown.
Nymex WTI, unlike Brent which is cash-settled, is a physical contract. If you hold the contract at expiration you need to take delivery of the barrels. Under normal market functioning, paper traders are rolling their positions into the future months well ahead of time without any fuss. But this time the usual physical buyers didn’t want the oil because they have nowhere to sell it and nowhere to store it. This created severe dislocation and a resultant implosion in the May WTI contract as paper traders found they had to offload positions without any liquidity or a bid in the market. It was a unique event, but one that reflects how financial markets can become very dysfunctional very quickly when things go bad.