Crude oil futures are a widely traded commodity, day traded, swing traded and used for hedging purposes. The difference between crude oil futures and equity futures is that crude oil futures expire on a monthly basis, and they are physically settled. That means if you buy 1 lot of crude oil futures and you hold it to expiration, and past, you will get assigned (depending on your broker) That means you will take delivery on 1,000 barrels of crude oil (which is the contract unit). Storing the product is not free! So let’s explore What Happens on Crude Oil Futures overnight? And why is Crude Oil Price dropping down rapidly?
In the most recent weeks, we have seen extraordinary price action and movement in the crude oil futures market, especially in the May 2020 contract expiry. For the first time ever, the price of crude oil hit negative numbers. Dropping to $37.62 to the negative. That means that producers were paying people to take crude off their hands! $37.62 a barrel just take the damned thing. That also means if you were to short the contract, into this drastic drop at your friendly broker, you would have been handed $37,620 per lot from ZERO. Now it sounds amazing, but AMP has just ended trading of the crude oil futures contract, the only trading that will be done is LIQUIDATION of your position. So where does that leave us? What will happen to crude oil now?
The futures contract rollover usually occurs 1-2 weeks before the actual expiry of the contract, so stuff like this doesn’t happen to traders, mainly assignment of the psychical product. Can we see the next month’s contract, the June crude oil contract trade negative before that even happens? We’re getting there. The contract hit $6.50 cents on the low end before rallying several dollars into the pit close.
In this article, we will talk about storing and assignment, what we can expect from crude oil in the future, and the famed crude oil ETF: USO.
What happened to Crude, will it hit negative again?
The first thing is WTI (West Texas Intermediate crude) hit a negative price for the first time in history. Long positions in crude and producers are trying to force someone to take their position, (anyone short must make the delivery) how so? By paying them, the fear of delivery is all too high with the current situation. There is a glut in the market and there is nowhere to store the product. These negative oil prices have been triggered by recent pandemic effects. The COVID-19 breakout was the starting catalyst for a lot of this crude oil dismay, which can also lead prices in US equities even lower than they were this week. The first part of the COVID-19 effects was on China, the massive country that provided the crude oil market with demand. The shutdown and extremely subdued demands were a starting point. Then came the feud between Russia and Saudi Arabia and the construction of OPEC++ that decided to prolong production cuts by 10 million barrels a day when the world was expecting 20 million barrels per day. The price war between the two nations actually ended up adding more crude Oil to the market than initially anticipated which did not help the oversupply issue.
What we witnessed early this week, on Monday, April 20th, 2020 was a phenomenon like no other. Have you heard of a short squeeze? This was just the opposite, a short squeeze forces short position holders out of the market by sharp market buying. While on April 20th, the short side was in control! Everyone was panic selling the market fearing they would have to take delivery, they did not want delivery because it would be near impossible to store. Not to mention the natural rollover participants who generally sell out of their positions to roll over to the next contract (June). The nearly negative $40 a barrel of crude was not a completely accurate representation of the whole crude market, rather just what was going on in this month’s contract. However, it should show signs of worry and interest, because it’s the first time we’ve seen something negative. Meaning the coming months, we may not see crude hold up too well. Not a completely accurate representation of the supply and demand principles of the WTI crude market.
Crude oil futures expiry- Super Contango
As prices rolled over to the June contract from May, we saw a HUGE difference in the two, often we don’t really see more than a 30-50 cent difference in contracts, but this time it was nearly $10 at the beginning of the day. The main question is why is the oil price dropping? The idea behind this pricing discrepancy is that traders, hedgers, producers alike speculated that the price of Crude in June would be $24.00. That quickly shifted. Instead, we saw SUPER contango. June becomes the front month when May expires and the position holders have made their transition, making June the heavier volume month. Contango is the condition where the futures contracts future months trade at a premium to the spot price (or the expiring month) Crude closed the June contract trading on Monday at $20.43, falling 18%. The difference between the two was astronomical which is why we call it SUPER contango.
The chart below is the price representation of the futures contracts to come, all of the future dates until September and December (purple) for good measure. You can see all of the contracts are trading in contango and the next contract after June (orange line) is July (yellow line). June is currently around $13.00 and on April 21st, 2020 it hit $6.50. While July traded at $19.91 too closeout. Which indicates further SUPER contango. The sheer difference suggests that we may be in for a repeat at the end of next month. While the months in advance are relatively closer to each other. Because that is what market participants expect prices to be in those months. There is optimism baked into these futures crude oil prices as they are not yet near the lower threshold we’ve seen. Market participants are expecting an economic recovery as the COVID-19 shutdown’s end and to see a demand spike for crude oil at the end of 2020.
Why did Crude Oil hit negative? Storage Issue
The next issue is the storage of the product. First, if you take delivery you have to store crude oil barrels somewhere and you’re getting them by the thousands. Storing is not cheap either, the US inventories are rising exponentially especially in the delivery center for NYMEX futures in Cushing Oklahoma. This grand oversupply is pushing limits and boundaries of storage in the US and in about 2-weeks if storage levels continue to rise we will see an all-time high of U.S inventories. Which are projected to reach max capacity in about two months, says Robert Yawger, director of energy at Mizuho Securities USA. If that manages to draw out until the June contract expiry which happens at the end of May as we just saw May expire at the end of April, we will test those boundaries 100%. Where the COVID-19 pandemic has to be taken into consideration. We may see negative crude for the second time from panic sellers avoiding delivery.
Crude Oil seasonality and Use.
Crude oil is used widely for transportation and energy generation. The top consuming countries of crude oil worldwide are the US, China, India, Japan, and Russia to name a few of the big fish. The fact that we are in a global quarantine means that the demand is going to remain low. International travel is closed, borders are shut down in the US. The main uses of crude oil are transportation, that includes jet fuel. 70% of crude oil in the US is used for transportation. This is why the June contract was expected to be over $20.00 making the difference between the current month and next over $10.00. The summer is the high season for travel and crude oil demand on a seasonal basis. The optimism was shut down with the oversupply, storage issues, and also the fact the quarantine may last a lot longer than everyone anticipated.
Theoretically, if we take the crude oil seasonality chart into consideration above. The seasonality for strong oil prices begins at the end of May and pushes into the end of September before a slight drop off. This is what traders, investors, and producers were expecting, it probably would have happened if we weren’t in this supply glut and COVID-19 pandemic. So now that it’s evident that things won’t continue as normal, panic selling and fear of assignment are taking over. Pushing the boundaries on the downside of crude oil and the storage available. The US is set to take on a 3-phase process to reopen the economy. The first phase still restricts travel, so that doesn’t help crude oil pricing. The second starts to open up travel for non-essential purposes, but with the fears of the virus still lingering who would be willing to hop on a plane to another country. Especially if the epicenter of the virus was once considered to be Europe. It seems like a long way before things return to normal and the population has confidence in travel and consumption of oil.
Oil Company bankruptcies
What does that mean for the future of crude oil, could we see massive energy companies go under? It’s already happening. Crude oil is so cheap will force a lot of companies to go under the oil industry. The Energy sector on the S&P 500 has already lost over 40% of its year to date value. Dropping as low as 60%. Which will cause company debt to increase drastically and many to go bust? Rystad has made an educated guess that the current oversized debt that oil companies have, of more than $70 Billion will be reorganized in bankruptcy. Which is only considering the remainder of 2020 and production and exploration companies, not those servicing the industry. Drillers, tool providers, and more. By 2021 the expectation is $170+ Billion of debt reorganization. The deciding factor is how long oil manages to remain at this detrimentally low price, the answer, how long it takes to reopen the economies. There could be a collapse of 100 oil companies filing for bankruptcy this year alone. In other respects, futures brokers are already liquidating contracts for June and closing out positions to limit their exposure. They’re also increasing futures margins so much that it makes it nearly impossible to trade the product without deep pockets. AMP futures just announced a $ 40,000-day trade margin for the June contract. To put it in respect, a few months ago day trade margin was $1,000. So that begs the question, will crude oil prices ever recover? Once the pandemic starts to subside and we start to get more demand and use of oil it will, the production is there, we just need demand desperately.
In some other news, we are seeing US Government intervention because it affects the economy as a whole. Can they go out and increase the price of oil directly? Probably not but Trump has suggested that there will be supportive measures for companies in the industry. The goal is to prevent further collapse and bankruptcies to further affect the economy. So we could see government intervention in that respect as we have seen the stimulus for the economy and US equities. OPEC ++ can only limit the supply so much without having any effect if the storage isn’t there. The cartel is not so powerful it seems.
United States Oil Fund meltdown.
Throughout this crude oil meltdown people were very interested in the futures market, along with oil companies, but there is one asset that had all investor eyes glued. USO or the United States Oil Fund. As futures went negative the USO contract dipped but did not go into the negative due to the fact that it is based on crude oil spot pricing. As of April 17, the USO fund rolls over their futures exposure (80%) of it to the next month’s expiry 2-weeks before expiration and the remainder to the month after. So they limit their exposure to a potential downturn into negative territory yet again. The USO fund also decided on a reverse stock split of 8:1, meaning they are increasing the price 8 fold and decreasing market share. If the current price based on the USO is $2.50/share as of April 22nd, 2020, that means by April 28th when the reverse stock split is put into play if everything stays constant USO will be 8 times more of $20.00/share. Why would they do this? This is protection against the downside, they are reducing the market cap as USO traded 1.5 billion shares on Tuesday. Reducing the potential of negative USO, it will have a long way to fall from $20 to get back down to $2.50 so the downside potential is deemed valid.
If you have shares they will be cut in 8 and the value of your position will stay the same. If you have USO call options or put options your options position will be cut in 8 as well.
Will the price of crude oil ever recover? An outlook on the price.
This is the big question, will we see crude oil recover? We’ve hit the -$37.62 low on the continuous futures contract below an all-time historic low when we rolled the contract over. Into June we saw the contract start at about $22.00-$23.00 and ever since it lost about half of that price. We hit as low as $6.50. So will we ever see crude back to the glorious $60+ level? In short, we may but it’s going to take a long time. We need to see the economy reopen and we need to see demand skyrocket, emptying the storage facilities. This will happen by border reopening and from there we can see a slow drastic climb, but will this happen this summer? It seems a little unlikely let’s see how the next rollover goes.
If you want to join with us in our live trading room, Check This Out.
If you prefer to trade more passively, check out our newsletter, trade ideas and live analysis in the Elite Trader package here > for Free News Update Click here.
The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.