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What just happened to Oil? The unthinkable became a reality in the front-month May contract as the price of WTI got slaughtered as low as -$40.00. Producers are at a point where they no longer have sufficient capacity to store all the surplus of Oil, so they’ll pay to get rid off it.
Let me show you first, via price bulletins and posted prices, where we stand in the American physical oil market by the close of New York. What once could not be fathomed (read replies), this pandemic keeps both schooling the uneducated and defying old beliefs and paradigms.
A picture speaks a thousand words, right? You probably want to print this image off, stick it on the wall and frame it nicely, especially if you were able to milk this trend to the downside.
By following trends, you get exposed to the maximum reward by following the flow. At times, when the proverbial hits the fan and things go haywire with technicals, fundamentals and overly speculative moves aligning, one could be in for a big pay day. That’s what happened to those short the front-month contract as some buyers will be leaking their wounds for years.
So, let’s touch briefly on the complexity of factors precipitating Oil front-month contract (May) to collapse in such a spectacular fashion.
Firstly, technicals were screaming sell on strength, with all the signals flashing red right after the failure by OPEC to desperately address the whole conundrum with the cuts announced not moving the needle, even if we must remember that these are applicable from May.
However, I am just reading news crossing the newswires that Saudi Arabia and other OPEC members are considering cutting their oil output as soon as possible, refusing to wait until next month, the WSJ reports. “Something has to be done about this bloodbath,” said a Saudi official familiar with the matter. “But it might be a little bit too late.”
By disseminating the fundametals, here is where we understand the ‘why’ this happened, as opposed to technicals, which gives us a response for the ‘how’ we got to where we are.
In a nutshell, there has been an utter extermination of the Oil demand as the world went into lockdown mode at a time when supply kept pumping at steady levels amid a harsh price war. This resulted in unseen reserve excesses, to the point that producers run out of space to store the output.
Here is the explanation offered by one of our Discord members:
@bbatrading makes a great point when he states that turning off Oil is not like ‘the tap in our kitchens’. Why? Because for sellers of oil, its damn expensive to shut down wells, oil pipelines, hence the problem at the storage facilities mounts as these are filling up towards capacity. Besides, one must think of the added costs and logistics involved if considering the transportation of oil from inland hubs to ships on the coast which have seen a steady cost increase for floating storage.
What about the speculative element? Well, as Forexlive and Forbes report, it looks as though every average Joe out there, alongside their dogs, have been busy piling into Oil (refers to front-month contract) through ETFs that would mick the price of it heavily to the long side. Besides, thrown into the mix some massive margin calls ongoing right now by some funds truly imploding.
First, a quick crash course on how the Oil market really works. The most popular contract out there is the CL, which is traded in the NYMEX market. This instrument, unlike spot forex, is a physical contract and it is deliverable. What this means is that if you are holding a long position in the CL by the end of the contract, which expires every month, you must take delivery, hence those who own the contract need to have a place to store the Oil.
The way it works is that each month, towards the end of the expiration date, most volume switches over to the next contract, which tends to be a seamless process with little variation in prices as the market is functioning properly and its price discovery is efficient. For days, the real action has been on the June contract, as reflected by the open interest which has been five times higher compared to May’s with staggering amount of volumes, even through the rollover period.
Back to the May contract, this time things were different, and as we roll over from the May contract, which expires this Tuesday, to the June, traders holding CL May contracts long are caught under a lot of pain. They had no options left as expiry is upon us to take delivery of physical crude oil at Cushing, Oklahoma, but’s it’s all filled up/booked. Therefore, panic ensued to run to the exits.
Think about it. With the current constraints in storage capacity by physical oil traders, there was little escape, which wouldn’t be the case and selling at $0 or canceling the contract would make more sense if they had space, as they could buy May crude oil, take delivery, store it and then sell it back into the market in June for a juicy profit.
The tricky situation now is that if the same storage issues arise in the June contract as this moves into expiration, we are risking a replay over the coming weeks to prices towards where the May contract ended. What could avoid that? A recovery in demand (unlikely at this stage), or a radical twist in the fundamental outlook through more aggressive production cuts, combined with more producers out of business, which would lead to accommodate more space to store Oil in the US.
Anyone who holds the view that today’s plunge into negative territory in the front-month oil futures contract is a one-off and can’t happen again would be solely misleading himself. The backdrop, unless the fundamentals revert, is looking extremely dire folks. The hope? Further OPEC cuts, the existing ones coming into effect, a successful transitions towards lifting social distancing that improves demand, and new measures in place by government to counter a similar move as more episodes like this won’t send the right signals for risk appetite.
These intricacies part of the CL contract are the reason why brokerage firms, including Global Prime, resort to the offering of a continuous Oil contract vs an expiration contract. This explains why in our ticker XTIUSD, the price remains stable circa $21.00, even if that still doesn’t reflect with the usual accuracy the contract pricing for June.
One thing we have noticed is the confusion that exist from how our GP CFD is priced and that can vary vastly (in this season) due to the spread between futures contracts. As we have just transitioned to next contract, our price is reflecting front month (June) fairly closely.
Global Prime’s liquidity provider averages the price between the two contracts (as they have to hedge in futures) and gradually shift positions over as it nears the expiry*. They then determine the price of our XTIUSD CFD product as a fair value estimation of spot based on the time to expiry weighted average to expiry.
*The rollover is the switching from the front month contract close to expire to the next front month contract. Some instruments we offer are based on futures contracts which our liquidity provider periodically roll. The rollover allows the account holder to maintain the current open position into the next month.
Another very noticeable anomaly going on in the markets is the outrageously high spread between the price of WTI (American pricing benchmark) and that of Brent (The European pricing benchmark), and also now considered as the global benchmark. The latter barely dipped a mere 4% hovering at US$27 per barrel, which reflects once again, the point made about storage constraints in the US as the European version of the CL contract doesn’t face the same storage issues.
Because of the nature of the contract, Brent can be delivered offshore to a variety of locations. What this means is that if no or little storage is left in one place, the mechanisms guarantee that it can be delivered elsewhere. This also helps to explain why the collapse in WTI saw Oil-sensitive currencies (CAD, NOK) unfazed by the hammering of CL1!
At this point in time, things aren’t as bad as if this is an Armageddon-type situation, which is what headline-grabbing tactics make it look like. The price for Brent tells us the real picture, even if things could keep getting ugly again, especially for WTI due to storage constraints.
The price action in the latter is a watershed moment and a reflection of the reality in the ground, comprised of a toxic cocktail that results in no one wanting physical oil amid the evaporation of storage room, demand and purpose to hold it.
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