What is oil contract trading, and could prices go negative again?

Matthew Farmer 15 May 2020 (Last Updated June 3rd, 2020 10:16)

As the Monday deadline for the June contract nears, Offshore Technology asks whether oil contracts could once again fall into negative prices.

What is oil contract trading, and could prices go negative again?
Oil contract traders are much more cautious now than a month ago, but another price crash is still possible. Credit: Сериал Бригадa.

On 20 April 2020, the May contract for West Texas Intermediate (WTI) oil delivery fell into negative territory, closing at -$37.63 on the NASDAQ stock exchange.

The headline story is easy to understand, but the complexity of what happened means this isn’t the full story. As the Monday deadline for the June contract nears, Offshore Technology asks whether this could happen again.

In April, the large number of investors selling WTI oil contracts caused prices to close at -$37.63. The oversupply of oil and lack of storage price contributed to the crash, but the crash had little to do with the physical supply of oil.

Explaining contract selling before the price drop

Oil contracts can be bought at any time. They guarantee the holder a certain amount and quality of oil, at a certain date in the future. As such, contracts are divided into months for when the holders will take the delivery.

The system works as a clever way of regulating supply and demand with pricing. Every month, oil must go, and prices can fall and rise to make sure suppliers get a good price for a fixed amount of oil.

However, investors saw that they could use the oil price fluctuations to make a profit. If a contract is bought cheap and sold when it is more in demand, big money can be made. But when time runs out, they must take delivery of the oil or pay a large cancellation fee.

Because most storage facilities were filling up and commodity investors do not generally have large oil storage facilities in reserve, many of them wanted to get rid of their contracts. On 20 April, many were still waiting to for a good time to sell. Eventually, they cut their losses and sold to avoid paying expensive storage fees on their May contracts. The market responded with a price crash.

WTI was previously seen as a good representation of the worldwide oil contract market. Since the huge growth in US shale oil extraction, banks such as Lehman Brothers said this is no longer the case. Since the boom, the WTI price has stayed lower than the most frequently-referenced benchmark, Brent Crude.

The two are not directly comparable, as each relates to a different quality of oil. Brent Crude contracts are exchanged for a low-density (light), low-sulphur (‘sweet’) crude oil. WTI oil is lighter and sweeter still. Interestingly, the ‘sweet’ label, and its opposite ‘sour’ label, are derived from oil prospectors who used to taste oil to test its sulphur content.

What this means for the June contract

The more widely-used Brent Crude index moved much more slowly, but still downwards. The following day, the contract fell to a 21-year low but did not plummet in the same way as WTI. In the month that followed, a slow recovery has taken place, despite news of US stockpiles nearing full.

On Wednesday, the US Commodity Futures Trading Commission (CTFC) warned traders to be prepared for WTI oil to once again go negative, as the June contract nears its expiry date. The commission warned, one month after the first nosedive, “registrants should remain vigilant and prepare accordingly”.

Trading has been a lot more cautious this month. On Tuesday, investors held contracts worth 155 million barrels of oil. At the equivalent time last month, they held 232 million barrels in contracts, according to commodities analyst and journalist John Kemp.

However, this was well above average with a short time to go before expiry. This could be why the CTFC issued its warning, saying traders should “take appropriate measures in response as contracts approach expiration”.

Former BP CEO John Brown has said he expects WTI may go negative again. While global oil demand stays low and storage stays near full, it is an unavoidable risk.

While prices have crept up slowly this week, the risk factors remain. Rystad Energy senior oil markets analyst Paola Rodriguez Masiu said: “We do not believe that storage is on its way to recovery [with] healthier, lower levels yet.

“The supply surplus has not gone away because of the storage levels losing a few thousand barrels this week. The market has not balanced yet and it will take some time for this to happen.”