April 2020 will arguably go down in history as the most unforgettable month commodity markets have witnessed to date. On 4/20, when May WTI crude oil futures settled at negative $37.60 per barrel, every commodity trader in the world’s perception of the word risk as they previously knew it was thrown out the window. Energy markets were quite literally flipped on their head as price implied sellers were ready to pay someone else $37.60 to take delivery of a product that someone was willing to pay more than $60 for only four months prior. To state the obvious, it was the first time in history crude oil futures traded negative, with the prior low being in the $9 range decades ago. This move literally broke the models that traders have relied on calculate risk for 50 years. CME Group had to change its options pricing and valuation model to the lesser known Bachelier from the world famous Black Scholes because Black Scholes can’t account for prices below zero. On March 16^th, the VIX, or volatility index (fear index) on the S&P 500 closed at an all-time high of 82.69, which represented an expected annual move of 82.69% in the S&P 500 over the next year. On Black Gold Monday, OVX, which is the equivalent instrument for crude oil, traded as high as 517.19, and closed at an eye-watering 325.15.

In addition to the horrible toll it’s taken on human health and global economies, COVID-19 brought on the largest exogenous shock energy markets have ever witnessed as cities, states, and nations across the globe entered into lockdowns, and people simply stopped moving. In just 35 days, US daily demand for gasoline fell by 5 million barrels (~50%), while diesel demand fell by 1.7 million barrels (~33%), and jet fuel demand fell by 1.5 million barrels (~70%). Amidst all of this, refinery throughput only fell by 3.5 million barrels (less than half of the total loss in demand), and most importantly, crude oil production in the US only fell by 800 thousand barrels (less than 10% of total demand loss). It doesn’t take a mathematician to figure out that the supply response clearly didn’t match the plunge in demand, which is exactly what caused prices to go negative.

Petroleum is unlike most other commodities such as corn, soy, or even copper. If too much is produced it can’t just sit in a field to let rot, or in a warehouse to wait around until demand recovers. Once it escapes the ground it must be contained in sealed storage containers where it can’t contaminate the environment. WTI crude oil futures are unique in the fact that they are deliverable to a US storage facility in Cushing, Oklahoma, which is land-locked, meaning it cannot be accessed via sea and must be delivered to via pipeline. WTI’s counterpart is Brent crude oil who’s trades are typically financially settled, meaning the counterparties don’t actually take delivery of the product, they just financially settle their gain and loss upon settlement. However, if two counterparties did agree to take delivery, Brent is deliverable to a platform in the middle of the Atlantic ocean, making its implied storage capacity multiple times the number at Cushing due to vast number of tanker ships on the sea. Cushing has a maximum capacity of 91 million barrels, and while there are many other crude storage facilities in the US such as the Strategic Petroleum Reserve locations, Cushing is the most scrutinized. If the US is producing and importing 4-6 million barrels per day more that they’re ultimately using, storage fills up at a rapid pace including at Cushing. What happens when space runs out at the place sellers are supposed to deliver to? Producers are ultimately forced to shut in, but what about price in the short term if the product can’t actually flow?

If you own a WTI contract at the time of settlement, you are contractually obligated to receive 1,000 barrels, or 42,000 gallons of sweet WTI crude oil, black gold, Texas tea, or any other name you want to give it by the last day of the month at Cushing, Oklahoma unless if you enjoy being sued into oblivion. One of the leading theories on what happened on 4/20/2020 is that a small number of people owned what little available storage remained unfilled at Cushing going into the final hours of trade (the contract settled on 4/21). The open interest going into 4/20 was 108,000 contracts, while the available storage was supposedly less than half that. This likely led to a large amount of “trapped longs” who either thought it couldn’t get any cheaper than the cash price (look up commodity futures convergence), or were banking on being able to find storage to take delivery and quickly discovered that none remained – something that never happened before. All the small number of players who had access to the remaining storage needed to do was pull their bids and watch the carnage unfold as the longs who had no business owning a physically deliverable contract so close to expiration violently dropped their offers into the literal abyss as they were either desperate to close their positions, hit with margin calls, or both. Goldman pointed toward inexperienced retail investors who could have been to blame, which could be explained by Interactive Brokers announcing a $89 million dollar loss related to crude price that day, which prompted most retail brokerages to allow closing trades only in June and August crude oil futures for their clients. Although this was on a much smaller scale, it was infinitely worse in terms of price action than what unfolded in the bond markets during 2008. JP Morgan buying Bear Stearns for $2/share has nothing on the guy who was on the buy side of the transaction that printed the low at -$40.32. Another theory I’ve read point to the futures and cash price convergence that happens as physical commodity markets near expiration, but I would argue this isn’t valid because if cash prices were anywhere near -$37 refiners would be DPA’d by the US government to help print the economic stimulus money (joke). A final theory which might hold some truth is that swap dealers and traders with swap expirations of settlement -1 day were scrambling to liquidate long futures against short swaps against what was obviously a very weakly bid market. Regardless of what happened it made for an epic intraday chart with a range of almost $60 as price closed -$55 per barrel, or almost -300%. The forward spreads were even more wild. At its most extreme point the May contract traded at a $69.73 discount to the June contract, meaning if you had access to storage in that moment, you could have bought the May contract to accept delivery, and sold the June Contract as a hedge to lock in a gross margin of almost $70/barrel, or $70,000 per contract to hold the physical liquid for just 30 days.

The United States Oil fund (USO) ETF has been in the spotlight nonstop throughout the recent carnage. The fund’s objective historically has been to mimic the price of WTI crude oil, mainly on the front end of the curve where price is normally most volatile, and representative of current price. It’s been widely known over the years as a favorite tool for retail and institutional investors to add exposure to raw crude oil to their portfolios because it does this by holding long positions in WTI futures contracts. The fund recently received a great deal of criticism from regulators and exchanges for holding a substantial percentage of the open interest in WTI crude contracts (25% at one point in the May 2020 contract). USO rolled out of all of its May contracts prior to it going negative, and is rumored to have rolled out of its June contracts earlier this week, about a week or two earlier than usual due to fears of a front month collapse below zero again. Earlier this week, Bloomberg pointed out that the fund recorded a net loss of $1.19 billion in March, including $466 million in realized trading losses on futures, and another $725 million on unrealized loss on market value of futures, both of which are in line with oil prices crashing 54% in the month.

Retail investors flocked to USO in the month of April, especially in the days when May first went sub-$20 and went negative for the first time. The combined trading volume on April 20 and April 21 was greater than the entire number of shares that changed hands in the 4^th quarter of 2019 as crude oil prices headlined financial and non-financial media outlets across the globe. Everyone wanted to own crude because it has to go up, right? What most new USO investors failed to realize was the adverse impact the forward curve was having on their investment thesis. Forward prices were (and still are to a lesser degree) trading at a steep forward carry, otherwise known as contango. This means the price of crude in the future was more expensive than the price in the period before it (August is more expensive than July, which is more expensive than June, etc, etc). When USO sells its current position in the less expensive July contract to buy the more expensive August contract, investors are hit with what’s called a negative roll-yield. To elaborate, when USO rolls its position from July to August, the price of USO doesn’t change, it just now owns a more expensive contract than it did the month before. USO investors only benefit when the price of the contract that it actually owns goes up in price. So say you paid $5 for shares of USO and the next day they rolled when July was at $20/barrel and August was at $25/barrel, you paid for $5 per share for $20 crude and now own $25 crude at $5 per share. If the August contract falls to $20, USO falls to $4 and you’ve just lost 20% even though the price of crude hasn’t really changed. In summary, as long as the forward curve is trading with steep contango, USO is objectively not the best instrument to bet on an oil price recovery. If you’re dead set on doing that I would lean more toward betting on one of the well capitalized mid-cap E&P companies like PXD, PE, EOG, or WPX (not that I’m recommending this – I don’t own any of these names).

This week’s EIA data did show signs of a bottom in product demand loss so there is a glimmer of hope we may be coming through to the other side of this.

A chart to show your grandkids:

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Will Clark