A Historic Though Overblown Lesson in Contango and Oil Futures Expiration

Before attempting to explain what happened in oil Monday, let's start with the basics. Commodities such as crude oil trade in futures contracts listed by the CME Group . According to the CME, the formal definition of a futures contract is as follows: A legally binding, standardized agreement to buy or sell a standardized commodity, specifying quantity and quality at a set price on a future date. The seller of a futures contract agrees to deliver the stated commodity on the stated delivery date. The buyer of a futures contract agrees to take delivery of the stated commodity at the stated delivery date. The only variable of a futures transaction is the price at which it is done, and buyers and sellers determine this in the marketplace. Do Futures Traders Take Delivery? Although the futures contracts bought or sold represent an obligation to take or make delivery, about 97% of futures contracts never result in physical delivery of the underlying commodity, according to the CME Group. Instead, traders simply offset their holdings before the expiration date. In the case of oil, only a select few can participate in the delivery process because doing so requires proper licensing and equipment (storing and transporting oil is a chore). Thanks to the standardization of each contract, the subsequent ease of buying or selling contracts, and a lack of default risk, futures trading has attracted price speculation. Participation is no longer limited to those who own or would like to own the underlying commodity. Instead, unrelated third parties can easily involve themselves in the markets in hopes of accurately predicting -- and, therefore, profiting from -- price fluctuations. Yet, these speculators must exit their holdings prior to expiration, which for the May 2020 contract is here on Tuesday, April 21. Cash Market vs. Futures Market Prices in the cash and futures market differ as a direct result of the disparity in the timing of delivery of the underlying product. After all, if a commodity is going to be delivered at some point in the future, it must be stored and insured in the meantime. At the expiration of a futures contract, the cash market price and the futures price converge. This is what ties a commodity futures contract to the underlying commodity. What Is Contango? The costs associated with holding the physical commodity until the stated delivery date are referred to as the costs to carry. Naturally, in normal market conditions, the cash price is cheaper than the futures price because of the expenses related to carrying the commodity until delivery. Likewise, the near-month futures price is generally cheaper than a distantly expiring futures contract. The progressive pricing is often referred to as a normal carrying charge market. You might also hear this scenario described by the term contango. Contango describes the upward sloping price curve from the front-month delivery futures contract through distant deliveries. Source: QST What Happened to the May 2020 Oil Contract? In a world in which there is nowhere to store oil once it is delivered, market participants eligible to take delivery of the underlying crude oil were non-existent. Further, when a contract goes into expiration, as the May 2020 oil contract is, futures brokerages restrict retail clients from trading in that contract. This is because it is difficult to police online traders who buy an expiring contract at the last minute. Instead, brokerages simply set their platforms to reject orders placed in the expiring contract. In this dramatic scenario, it created a market void of buyers but chock full of sellers who were forced to sell futures to exit positions. In short, these sellers were doing so because they must, not because they wanted to. Accordingly, as the trading session wore on, price became less of an issue; the priority quickly became making it out alive. As scary as it is to look at the carnage occurring in the May contract, the back months held up relatively well. In short, Monday's oil crash can be categorized as fake news. It was a front-month futures contract that most brokerages had blocked clients from trading due to the impending expiration. I suspect last week's inexperienced bottom fishers needed to exit positions ahead of expiration but couldn't find the liquidity needed for reasonable price discovery. Also, traders still holding an expiring futures contract this deep into the process are generally those preparing to be part of the delivery process, but with oil storage capacity maxed out there was no desire to take delivery of oil that cannot be stockpiled. As a result, there were no buyers and all sellers. In addition, the cash market transactions had been taking place under $10 a barrel for weeks, and the futures and cash market needed to converge. Unfortunately, illiquidity and the lack of interest in taking delivery caused the convergence to get out of hand. The open interest May oil on Monday was roughly 100,000 contracts in comparison to the June contract with nearly 600,000 and July at nearly 400,000. Thus, the headlines pointing toward negative oil prices were misleading in that they failed to mention this price anomaly was an exception rather than the norm. This is the first time a commodity has gone below zero. This is also the first time demand has dried up overnight at the hands of a government-induced economic shutdown. If we think about it, what happened in oil this week isn't much different than what we have seen in other industries; it just happens to be on a bigger and more transparent stage. Some restaurants, car dealerships and retail stores have liquidated inventory at fire-sale prices to prepare for and survive the lockdown; that is precisely what the oil market is in the process of doing. In other commodity markets, the product can be stored or destroyed to prevent price fallouts. But unlike milk, which can be poured away, and natural gas that can be flared, oil cannot be easily withheld from the market. The implications of the front-month contract are real, but they are likely temporary. Even after overnight liquidation in some of the back months as the market works out margin call selling and capitulation, we are looking at per-barrel prices in the $20s and $30s as we get deeper into 2020 deliveries. The oil market needed to contend with an extreme but somewhat transitory phenomenon. After all, the U.S. is slowly turning back on the economy and, therefore, energy consumption, and oil producers around the globe have been forced to slow down production. The cure for low commodity prices is low commodity prices.

A Historic Though Overblown Lesson in Contango and Oil Futures Expiration

Monday's crash in May oil futures can be categorized as fake news, as what happened in crude isn't much different than what we've seen in other industries.

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