Wednesday, May 20, 2020

America’s Oily Dilemma

     There have been many expressions of amazement and bewilderment over the recent news that “crude oil is trading at negative values.” This excessively simplified statement of the situation is somewhat misleading, as oil itself is not being “sold” for a “negative price.” What’s really happening is the descent of oil futures contracts – sometimes called commodity options – into the negative numbers.

     If you’ve never played the futures market – for my sins, I have – it involves contracts with two ends: the put end, which agrees to supply the commodity at a specified price, and the call end, which agrees to purchase and take delivery of the commodity. Futures contract trading goes like this:

     Smith purchases a futures contract on commodity X from Jones. The contract entitles and obligates Smith to purchase a fixed amount of X at a price of $Y (which is normally more than X’s current market price) on the contracted date. He must complete that purchase unless he can resell his contract to another willing buyer before the contracted date. By selling the contract to Smith, Jones becomes entitled and obligated to sell Smith the agreed upon amount of X at a price of $Y on the contracted date. Let’s say the price Smith pays for that contract is $Z.

     Why did Smith do this? Equally to the point, why did Jones cooperate with him? In the usual case:

  • Smith believes that he will be able to sell his contract for more than $Z – perhaps as high as $A – at some point before the contracted date. Thus he could reap a profit of $A minus $Z on the contract – possibly even by selling it back to Jones – without ever having to pay for or take delivery of the X.
  • Jones believes the reverse: i.e., that the going price of a futures contract on X will be less than $Z on the contracted date. If that is so, then (unless Jones actually has X to sell) he will soon purchase a canceling contract on X at a lower price $Q, the difference ($Z minus $Q) being his profit. It will become Smith’s problem to deal with the obligations and consequences of having purchased the original contract.
  • Note that in most cases, neither Smith nor Jones is actually interested in X itself. They’re merely gambling on its price movements.
  • Of course this omits any transaction costs involved – there are always some – but the essence of the thing really is that simple.

     Indirectly, both players are betting on a price movement in commodity X: Smith is betting that it will go up, Jones that it will go down. If it goes far enough above $Y before the contracted date, Smith will profit as he hoped, for someone – call him Davis – willing to bet that it will rise even further will be willing to purchase Smith’s contract for more than the $Z Smith paid for it. Alternately, some other buyer – call him Brown – who actually wants to take delivery of the X might purchase it in the hope that it will lower the effective price of X to him.

     Of course, if the price of X should fall (or fail to approach $Y), the value of Smith’s contract will fall as well. In that case Smith must hurry to sell his contract at a loss...possibly even back to that smirking bastard Jones. In the worst case, Smith might have to pay someone to accept the contract and its obligations. Because far worse than a mere monetary loss on the contract might be in prospect:

Should Smith fail to rid himself of his contract by reselling it, it is he who will have to fulfill it: by paying the $Y and taking delivery of the X. For the typical futures trader, that would be a disaster.

     Remember: somewhere in the great American supply chain, X is being produced and readied for delivery. And like a pipe, every link in the supply chain must have two ends: the end being fed with the commodity, and the end that takes delivery of it, whether to make actual use of it or to resell it. No matter how many links the chain may possess, the ultimate source must deliver; the ultimate destination must pay and take delivery. The flow must remain smooth or commerce in the commodity will shudder. In the worst case, it might stop.

     Futures contracts are traded in many commodities. Some of the best known are precious metals, oil, porkbellies, soybeans, and frozen orange juice. Dan Aykroyd’s and Eddie Murphy’s marvelously funny yet informative movie Trading Places concerns an attempt to corner the market in frozen orange juice, one of the most volatile of all futures contracts.

     Men have amassed huge fortunes in the futures markets. Others have gone to prison or committed suicide over their losses. Here’s a snippet of dialogue as Aykroyd’s and Murphy’s characters approach “the last bastion of pure capitalism: the New York Mercantile Exchange:”

     Aykroyd: Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That's the other guy's problem. Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness. Super Bowl, World Series - they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits and you take no prisoners. One minute you're up half a million in soybeans and the next, boom, your kids don't go to college and they've repossessed your Bentley. Are you with me?

     And that, Gentle Reader, is exactly how it goes.

     Now, concerning oil: taking delivery requires storage capacity, and just now there’s no surplus of it. So it’s deadly dangerous to trade in oil futures without due attention to the contracted dates. A single tradable futures unit of oil is 1000 barrels – approximately 42,000 gallons of oil. Most futures traders don’t have storage capacity for any oil; they’re relying on being able to resell their futures contracts before the contracted dates. So under current circumstances – i.e., the worldwide economic slowdown precipitated by the Wuhan coronavirus – where far less oil than normally is being purchased by end users, there’s a glut that’s flooding the available storage capacity.

     At this time, if Smith holds a futures contract on oil, then unless he owns a refinery he needs to pay someone to take the contract, and its associated obligation, off his hands. The alternative would be for Smith to complete the purchase and take delivery of the oil. That’s what it means to say that “oil is trading at negative $37.” The price of an actual, tangible barrel of oil isn’t negative; it’s just that at this time there aren’t enough buyers for the volume being extracted. That’s put the futures market in oil into a meltdown.

     When I first learned about the futures market, I was perplexed. I couldn’t find a justification for it. The typical futures trader is essentially a gambler in a high-stakes game of “chicken.” While there must be an ultimate seller and an ultimate buyer for every unit of every commodity, the overwhelming majority of futures trades never come near the associated physical commodity.

     He who educated me about futures trading put it thus: When futures contracts came into being, it was for perfectly good reasons: those who bought and sold them sincerely intended either to provide the commodity or to accept and pay for it. Those contracts had a cash value that would fluctuate as the price of the commodity fluctuates. That made them something people with lower-than-average risk aversion would be willing to trade in for their own sake: i.e., for the pure possibility of profit. So while the great majority of such trades remain remote from the commodity itself, there is actual, tangible economic substance at the “far ends” of the contractual pipeline. You just have to squint to see it.

     To close this presentation, have a delightful little piece I found this morning at Ace’s place:

     For my friends who ask how oil that was trading could be negative $37/bbl last week...

     Thomson Energy analysis - UNDERSTANDING Crude Oil trading at minus -$37

     Imagine the following scenario: You pay $500 today and commit to receiving a hooker at your house in 15 days because your wife will be traveling. This is called a Futures Contract.

     Unfortunately, lockdown came and you are locked down with your wife at home for the next 60 days. This is called “now you are fucked,” and you cannot fulfill the escort company's Futures Contract.

     So now you do not want this woman to show up at your house at all, and try to find anyone of your friends to pass off this futures contract, any neighbours or, anybody. But you find no takers because now everybody is under lockdown with their wives and families. You find you cannot sell this hooker commitment because nobody can take delivery of the girl, and there is no where to stash her. Nobody can receive the hooker at home anymore. Everyone is in full storage.

     To make matters worse, not even the pimp (Chicago Mercantile exchange) who sold you the hooker contract has more room to receive girls because his house is full of girls out of work under lockdown.

     So now you will have to pay anyone just to take the girl off your hands. So someone tells you I will take the girl off your hands but you pay me $37 to do it.

     This is called negative price when you deliver the girl that cost you $500 to the willing buyer and pay him $37 to take delivery.

     Got it? This in a nutshell is what happened to the Oil Futures Market last week.

     No need to thank me.....

     Have a nice day.

1 comment:

Tracy Coyle said...

Back in the 80's, I worked for a Futures Trading Group that was based in Chicago - I took customer orders and passed them to our trading desks in the relevant marketplace. (NY and Chicago)

I also worked out a trading program that one client used successfully till he 'adapted' it to be more hands off: it was designed to engage within the last 15 minutes and first 30 minutes of the trading days and required absolute purchases if flagged regardless of price - he used stops that often put us in the wrong position going forward. He was up >500k when he added his adaptation and lost about half of that before abandoning the entire system.

But when I started, a trader on the Merc's floor and I talked in detail about the foundation of the system and one thing that stuck with me (and I used for the system eventually) was that the contracts BORE NO CONNECTION to the underlying CASH markets. A very counter-intuitive statement.

Which is why I've avoided those markets to this day. However, a well connected (digitally) day trader close to the markets can still do very well.

Otherwise, is a strange place to be 'investing'.