Whoops! WTI Didn’t Do It Again, or, Lightning Strikes Once
The June 2020 WTI contract expired with a whimper rather than a bang yesterday, thereby not repeating the cluster of the May contract expiry. In contrast to the back-to-back 40 standard deviation moves in April, June prices exhibited little volatility Monday or Tuesday. Moreover, calendar spreads were in a modest contango–in contrast to the galactangos experienced in April, and prices never got within miles of negative territory.
Stronger fundamentals certainly played a role in this uneventful expiry. Glimmers of rebounding demand, and sharp supply reductions, both in the US and internationally, caused a substantial rally in flat prices and tightening of spreads in the first weeks of May. This alleviated fears about exhaustion of storage capacity. Indeed, the last EIA storage number for Cushing showed a draw, and today’s API number suggests an even bigger draw this week. (Though I must say I am skeptical about the forecast power of API numbers.). Also, the number of crude carriers chartered for storage has dropped. (H/T my daughter’s market commentary from yesterday). So the dire fundamental conditions that set the stage for that storm of negativity were not nearly so dire this week.
But remember that fundamentals only set the stage. As I pointed out in my posts in the immediate aftermath of the April chaos, technical factors related to the liquidation of the May contract, arguably manipulative in nature, the ultimate cause of the huge price drop on the penultimate trading day, and the almost equally large rebound on the expiry day.
The CFTC read the riot act in a letter to exchanges, clearinghouses, and FCMs last week. No doubt the CME, despite it’s Frank Drebin-like “move on, nothing to see here” response to the May expiry monitored the June expiration closely, and put a lot of pressure on those with open short positions to bid the market aggressively (e.g., bid at reasonable differentials to Brent futures and cash market prices). A combination of that pressure, plus the self-protective measures of market participants who didn’t want to get caught in another catastrophe, clearly led to earlier liquidations: open interest going into the last couple of days was well below the level at a comparable date in the May.
So fundamentals, plus everyone being on their best behavior, prevented a recurrence of the May fiasco.
It should be noted that as bad as April 20 was (and April 21, too), the carnage was not contained to those days, and the May contract alone. The negative price shock, and its potentially disastrous consequences for “fully collateralized” long-only funds, like the USO, led to a substantial early rolls of long positions in the June during the last days of April. Given the already thin liquidity in the market, these rolls caused big movements in calendar spreads–movements that have been completely reversed. On 27 April, the MN0 spread was -$14.45: it went off the board at a 54 cent backwardation. Yes, fundamentals were a major driver of that tightening, but the early roll in the US (and some other funds) triggered by the May expiration clearly exacerbated the contango. Collateral damage, as it were.
What is the takeaway from all this? Well, I think the major takeaway is not to overgeneralize from what happened on 20-21 April. The underlying fundamentals were truly exceptional (unprecedented, really)–and hopefully the likelihood of a repeat of those is vanishingly small. Moreover, the CME should be on alert for any future liquidation-related game playing, and market players will no doubt be more cautious in their approach to expiration. It would definitely be overlearning from the episode to draw expansive conclusions about the overall viability of the WTI contract, or its basic delivery mechanism.
That mechanism is supported by abundant physical supplies and connections to diverse production and consumption regions. Indeed, this was a situation where the problem was extremely abundant supply–which is an extreme rarity in physical commodity futures markets. Other contracts (Brent in particular) have chronic problems with inadequate and declining supply. As for WTI being “landlocked,” er, there are pipelines connecting Cushing to the Gulf, and WTI from Cushing has been exported around the world in recent years. With the marginal barrel going for export, seaborne crude prices drive WTI. With a better-monitored and managed liquidation process, especially in extraordinary circumstances, the WTI delivery mechanism is pretty good. And I say that as someone who has studied delivery mechanisms for around 30 years, and has designed or consulted on the design of these contracts.