The 20 minutes that broke the American oil market

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(Bloomberg) – From the start, on April 20, it was obvious that the oil market was in trouble.

Unbridled sell orders had poured in overnight and all traders who connected to the Nymex platform that morning could see a bloodbath coming. At 7 am in New York, the price of a key futures contract – West Texas Intermediate for May delivery – was already down 28% to $ 13.07 a barrel.

Thousands of miles away in the Chinese metropolis of Shenzhen, a 26-year-old woman named A’Xiang Chen watched the events unfold on her phone in amazed disbelief. A few weeks earlier, she and her boyfriend had sunk their entire nest of about $ 10,000 in a product that the State Bank of China dubbed Yuan You Bao, or Crude Oil Treasure.

As the night wore on, A’Xiang began to prepare to lose everything. At 10 p.m. in Shenzhen – 10 am in New York – she checked her phone one last time before going to bed. The price was now $ 11. Half of their savings had been wiped out.

As the couple slept, the rout deepened. The price has established a new low after a new low in rapid succession: the lowest since the Asian financial crisis of the 90s, the lowest since the oil crises of the 70s, the first time below zero.

And then, in one of the most extraordinary 20-minute intervals in the history of financial markets, the price hit a level that few, if any, imagined. Around the world, Saudi Arabian princes and wild hunters from Texas and the Russian oligarchs watched in horror as the world’s most important commodity closed the trading day for less than $ 37.63. This is what you have to pay someone to get you out of the barrel.

Many things about the explosive and flash-crash nature of the sale are still not fully understood, including the important role that the Crude Oil Treasure fund played as it sought to break out of contracts May hours before. their expiration (and other investors found themselves in the same situation). What is clear, however, is that this day marked the culmination of the most devastating oil market crisis in a generation, the result of demand drying up as governments around the world blocked their economies to attempt to manage the coronavirus pandemic.

For the oil industry, it was a grimly symbolic moment: the fossil fuel that helped build the modern world, so precious that it became known as “black gold”, was no longer an asset but a liability.

“It was breathtaking,” said Keith Kelly, managing director of the energy group at Compagnie Financière Tradition SA, a leading broker. “Do you see what you think you are seeing?” Are your eyes playing tricks on you? ”

ETF American Bread

While Monday’s deeply negative prices were largely limited to the United States, and in particular the WTI contract, which will expire soon for delivery in May, the world has felt shock waves, with knock-on effects world prices at their lowest since the late 1990s.

Traders are still gathering the confluence of factors that led to the collapse. And regulators are looking into the matter, according to people familiar with the subject.

However, for small investors in Asia like A’Xiang who are keen on oil, this is a calculation.

She woke up to a text at 6 am from the Bank of China informing her that not only had their savings been lost, but that she and her boyfriend could in fact owe money.

“When we saw the price of oil start to plunge, we were ready for our money to be gone,” she said. They did not understand, she said, what they were getting into. “It did not occur to us that we had to pay attention to the foreign forward price and the whole concept of contract turnover. “

In total, there were some 3,700 retail investors in the Bank of China Treasure Oil fund. Collectively, they lost $ 85 million.

Events would soon overtake US investors who had made the same bet as Xiang – that oil was to rise – by buying the United States Oil Fund, an exchange-traded fund known as USO.

The fund, which investors poured $ 1.6 billion into the week before, had not signed the May WTI contract on Monday. But the rout sparked a chain reaction in the market that also burned these investors.

The events of the day were unleashed more than two weeks earlier, with the pandemic shattering the economy and the demand for oil stalled: the flights were grounded; the traffic jams have disappeared; the factories stop.

The below zero price scenario was beginning to be seen in some corners of the market. On April 8, a Wednesday, CME Group Inc, which owns the oil futures market, informed its customers that it was “ready to handle the situation of negative underlying prices in major energy contracts.”

This weekend, the producing countries led by Saudi Arabia and Russia finalized their response to the crisis: an agreement to reduce production by 9.7 million barrels per day, or one-tenth of world production. It wouldn’t be nearly enough. Refineries have started to close. Buyers of oil shipments for immediate delivery to physical markets have disappeared.

Futures prices have remained relatively stable for some time.

This is partly thanks to people like A’Xiang. In China, investors, large and small, were betting on rising commodity prices, believing that the world would defeat the virus and demand would rebound. Bank of China branches have posted ads on Wechat, showing a picture of barrels of petroleum gold under the title “Crude oil is cheaper than water.”

However, on April 15, CME offered its customers the opportunity to test their systems to prepare for negativity. That’s when the market really woke up to the idea that it could actually happen, said Clay Davis, director of Verano Energy Trading LP in Houston.

“It was then that the dam broke,” he said.

Physical delivery

By Monday, April 20, most ETFs and other investment products – but not the Crude Oil Treasure fund – had moved their position from the May WTI contract to the following month.

Futures contracts are settled by physical delivery, and if you happen to end up with one when it expires, you become the owner of 1,000 barrels of crude oil. This rarely happens to this.

But now it was.

The physical settlement of the WTI benchmark takes place in Cushing, Oklahoma. When the storage tanks fill up, the expiring contract price can plunge and disconnect from the world market. As demand evaporated, Cushing’s stocks soared. In March and April, they climbed 60% to just under 60 million barrels, out of a total working capacity of 76 million – and analysts estimate that much of the remaining space is already reserved.

Thus, on the crucial Monday, the penultimate day of trading in the May WTI contract, there were few traders able or willing to take delivery physically.

A large part of the market was then concentrated on the settlement price, determined at 2:30 p.m. At New York. Investment products – including those from the Bank of China – generally seek to reach settlement prices. This often involves what are known as settlement contracts, which allow oil traders to buy or sell contracts in advance regardless of the settlement price.

No buyer

That afternoon, with lean trade volumes and more sellers than buyers, settlement transaction contracts quickly went to the maximum allowable discount of 10 cents per barrel. For about an hour, from 1:12 p.m. until 2:17 p.m., the negotiation of these contracts almost disappeared. There were no buyers.

The result was the carnage this afternoon. At 2:08 p.m., the WTI became negative. And then, a few minutes later, it went down to minus $ 40.32 before rebounding slightly at the close.

“The settlement negotiation process has failed,” said David Greenberg, president of Sterling Commodities and former member of the board of directors of Nymex. “It shows the fragility of the WTI market, which is not as big as people think. “

Prices in the US physical market, set by reference to the WTI regulations, also plunged, with some refiners and pipeline companies posting prices to their suppliers as low as $ 54 per barrel.

The investment product from the Bank of China explains why going below zero was so dangerous. The bank had asked investors like A’Xiang to pay the full cost of what they bought in advance. This meant that the bank’s position seemed risk free.

But not if the prices fell below zero: then there would not be enough money in the investors’ accounts to cover the losses.

The bank held a total of about 1.4 million barrels of oil, or 1,400 contracts, according to a person familiar with the matter. He had to pay about 400 million yuan ($ 56 million) to settle the contracts.

Others in the investor world faced similar risks. ETFs could go bankrupt if the price of the contracts they held fell below zero. Faced with this possibility, they transferred a large part of the assets in the subsequent delivery months. Some brokers have banned clients from opening new positions in the June contract.

These movements resulted in a new wave of sales that swept through the oil markets. On Tuesday, the June WTI contract plunged 68% to a low of just $ 6.50. And this time, it was not limited to American contracts: Futures Brent also plunged, reaching a 20-year low on Wednesday at $ 15.98, pushing up the price of oil from Russia, the Middle East and d ‘West Africa compared to levels close to zero.

The CFTC’s top priority

Harold Hamm, president of Continental Resources Inc., has called for an investigation, saying that the dramatic plunge in the final minutes of Monday “strongly raises suspicions of market manipulation or a new, defective computer model. “

In the Commodity Futures Trading Commission, unpacking what happened during those final trading minutes on April 20 has since become top priority, according to people familiar with the subject. While reviews and investigations of what happened are just beginning, senior officials so far believe that these changes were likely the result of a confluence of economic and market factors, rather than the result of market manipulation.

One issue the CFTC is investigating is whether the storage capacity data released by the U.S. Energy Information Administration accurately reflects the actual availability of space, two people said.

“The temporarily negative price at which the WTI Crude futures contract was negotiated earlier this week appears to be rooted in fundamental supply and demand challenges alongside the special features of this futures product,” said the president. CFTC Heath Tarbert to Bloomberg News.

Nonetheless, he added: “The CFTC is conducting an in-depth investigation to understand why the price of WTI has moved with the speed and magnitude observed, and we will continue to monitor the role of our markets to facilitate convergence between spot prices and ultimately at maturity. “

The CME, for its part, argues that Monday’s dip was a demonstration of the efficient functioning of the market. “The markets have worked exactly as they are supposed to,” said CEO Terry Duffy at CNBC. “If Hamm or other ads believe the price should be above zero, why wouldn’t they have stood there and taken every barrel of oil if it was worth something more? The real answer is that it was not at that time. ”

Who is right, the events of the week forever changed the oil market.

“We have witnessed history,” said Tamas Varga, an analyst at PVM brokerage. “For the sake of stability in the oil market,” this “should not happen again.”

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