Crude Oil Futures Really Starting to Come Back to Life

Crude Oil Futures

The price of oil simply wilted under the heat of the coronavirus lockdown. As things inch more and more towards normal, oil is rising as fast as it fell, and there’s lots more room to grow.

It was only a month ago that the price of oil touched minus $40 a barrel, during a mad scramble to settle the current contract for West Texas Intermediate, or WTI. This not only saw the futures price go well into the negative, it also caused spot prices to do the same thing for a time.

This was a completely bizarre situation that was caused by a combination of the price of oil getting slammed by the sheer lack of demand caused by the lockdown, together with a serious lack of storage capacity, along with traders tossing around expiring contracts like a hot potato, with each one that touched it getting burned more and more.

The great majority of oil futures contracts get settled prior to expiration day, and sensible traders seek to avoid being caught in a squeeze on the last day. They may still trade the contract on the last day, but this was no time to be on the wrong side of this.

The short side on that day delivered profits beyond the wildest dreams of traders, but the long side was beyond their worst nightmare. Given how leveraged futures trading is, what was a huge move in nominal terms became magnified to the extreme.

What we needed to realize at the time is that one day of an expiring futures contract does not tell that big of a story, and what really happened is that a bunch of traders got caught with their pants fully down and paid a big price for it.

While that all certainly told an interesting story, with the great majority of futures traders already fully moved over to the next month’s contract, what happened with the previous one at expiration was merely an artifact at that point. It was plenty real to the traders involved, but didn’t affect the overall WTI futures market very much, which stayed well in the positive through this.

This incident did reveal a big crack in the oil market though, which was how much we were using our existing storage capacity. The normal storage capacity for oil can handle quite a bit, but just isn’t designed for us to continue to pump it at the rate we were when demand has been curtailed as much as it had.

It turned out that the situation was nowhere near as bad as it was held to be, and the futures expiration fiasco occurred during the time where our storage capacity was underestimated, and a real crisis was brewing. Once it became known that we had more storage than we thought, this was a game changer, and together with cuts in production, this took the outlook for oil from grim over the next couple of months to a time where a recovery was around the corner once the economy opened up.

What people need to realize about futures is that they aren’t moved by changes in supply and demand of a commodity per se, they move based upon changing beliefs about supply and demand in the future. Once we knew that things were going to improve soon and the demand for oil will pick up, it wasn’t a matter of waiting for more people to fill their tanks, as the fact that we could be reasonably certain that they will soon was plenty enough to move the price of oil upward.

We could already see this materialize at the bottom of this move, back on April 21 when the current contract dropped all the way to $11.57 per barrel. Some had predicted single digit oil prices when the Saudi Arabians started a price war a little earlier, and we came pretty close to that, but even then, you could see the market pricing in a recovery when you looked at the contracts beyond the current month and saw the prices rise substantially with each month.

With so much uncertainty surrounding re-opening, with most of the stay at home orders out there set to expire in late April to early May, and the risk that these could get pushed ahead as well as what extent of activities would be allowed initially, we really needed to start seeing the people hitting the streets before we could start pricing in too much.

The Oil Market Needed to See the Recovery in Action First

In particular, traders needed to see a re-opening that did proceed well enough that it could be maintained, which we ended up seeing when Georgia took the lead in this. While we already had evidence of this not causing a spike in infections, as well as the experience of states that did not lock down at all to rely on, there still was quite a bit of concern out there about this.

It wasn’t until April 29 that oil futures finally woke up out of their slumber, when we saw the first attempts at re-opening states that had been locked down without incident. As the days passed, and these re-openings proceeded as planned, this further bolstered the idea that demand for oil will be moving in the right direction, and this was enough to take the price of WTI futures from $12.34 to $33.98 in a little over three weeks.

While we still see oil prices go up with each contract, all the way to $56.14 for the February 2031 contract, the differential between the months is a gradual one now, unlike a month ago when we saw some big differences over the forward few months. These higher prices did serve to show more organic stability in oil than appeared just by looking at the current contract, just as the further bullishness that these much more modest increases over time does right now.

We do need to keep in mind though that the gradually higher prices that these oil contracts are trading at right now does not mean that this is how the price of oil will proceed, that it may take us over 10 years to get to the February 2031 price of $56 per barrel, because these prices are based upon what we know and believe now, and get updated as the situation changes just like the current contract does.

$56 a barrel for WTI is pretty close to the $61 that we started 2020, and while the impact of the economic shutdown was profound, this is not a situation that should take very long to recover from, and especially not over a decade. While there may be lingering effects of this, people being afraid to fly for a while for instance, it is unimaginable that the demand for oil will be so substantially depressed for all that much longer.

The more conservative progression that we see in further out contracts are therefore by nature on the conservative side, and in situations like this, it is normal for the outlook to be tempered down as we wait for the positive beliefs behind it to materialize more. This does create an opportunity for those who may wish to ride this wave.

While we will see capacity increase as we move forward with the re-opening, given what has happened, we would expect to see more restraint with producers than normal, especially as current reserves get drawn down enough to return to normal. Even in the midst of a price war when this hit, when you drop from $54 a barrel on the day that the crisis really hit to below $12, the coronavirus itself knocked off $42 per barrel off the price of oil.

We have made back exactly half of this already, $21, with $21 more to go in order to get back to the price on February 20. What markets do is price in various amounts with varying degrees of certainly, where when the belief later becomes stronger, more of this amount is priced in.

This is where we are at now, and while the residual effects of this shutdown need to be calculated in, and therefore we don’t want to say that there is a whole $21 of room to go, there is more than enough room left to make oil still look pretty bullish indeed over the next few months, until we get to the point where we fully price in the ensuing recovery.

Oil is clearly on a strong upward trend, and over the last three weeks has delivered some phenomenal results to traders on the long side of it. Unlike with some commodities such as gold though, there really isn’t a good way to trade oil without using a real futures account.

Oil ETFs Are Beyond Terrible, But You Can Trade Oil Futures on Your Own

We already warned in a previous article against the biggest oil ETF out there, the U.S. Oil Fund (USO), but for the benefit of those who might be thinking that this might be a good way to take advantage of the continued bullishness in oil, we need to show you why this is a bad idea.

The easiest way to show how much USO goes down more and how it doesn’t go up as much is to look at the year to date performance of it compared to how WTI futures have done. WTI is down 44% in 2020. USO is down 78%. That’s unspeakably bad.

USO is supposed to track the current contract of WTI, but in reality, it is instead an assortment of contracts and they were a big player in the expiration fiasco, even though are supposed to get out of a contract two weeks prior to expiration. They are also holding a lot of cash in the aftermath, which has led to their only moving up 56% since April 28, while WTI has gone up by 166% since.

This is nothing compared to how the number two oil ETF, the ProShares Ultra Bloomberg Crude Oil, has fared. In spite of the rebound, it is down an unbelievable 95% for the year. While USO has messed up terribly, the second biggest oil ETF has been simply butchered.

While the ProShares one is leveraged 2x, and this did make the loss when the price went down a lot bigger, what’s really notable is that the fund has only risen by 95% since April 28, when it should have doubled the 166% that WTI moved up, or something close, not go up by this much less.

This was uglier on the downside as well. Doubling a 44% loss adds up to 88%, not the 98% that the ProShares ETF plunged. When you are in an ETF that loses a lot more when the asset you’re tracking goes down, and gains even less on the way up even though it’s supposed to earn about twice as much, we can only feel sorry for those who invest in this fund.

These ETFs are horribly managed, and when you take an asset price that you are supposed to track and miss by amounts that can only be described as horrendous, it’s not the price of oil that is to blame, this is human error, and loads of it.

Those who do want to capitalize on oil’s further potential from here can just trade the futures contract and have it roll over at expiration, allowing you to stay in the position for as long as you like. People need to be careful not to use too much margin with this trade though, and this isn’t even a matter of skill, as higher leverage is just not suited for anything beyond the very short term, where you can tightly manage your risk.

You can’t do that holding over a longer period, like the several weeks to several months that we’re talking about with this trade, as you need to be able to ride out the bumps along the way. When you use a lot of leverage, these normal bumps on a longer timeframe are simply too big to go over and can get you in serious trouble.

Two times leverage is plenty for the purposes of this trade, and more than that will require a lot more skill than armchair traders typically have, and even the best wouldn’t want to use a whole lot more than this if they were looking to hold over this timeframe.

The beauty of this trade is that we have an unusual degree of certainty of oil prices climbing from here, and even this far along in the move, we can still trade this with a reasonable amount of confidence. Where oil will go over the next few weeks is usually a guessing game, and while you can guess good enough to get a little edge, the lack of guesswork right now makes this edge a whole lot bigger.

Opening a futures account can be useful for other things as well, especially since you can also trade in stock index futures with it, where you can seek to take further advantage of bull markets with stocks and also use this as a hedge when you’re worried about stocks taking a tumble.

While it’s still generally better to just get out of the stocks instead, investors who are concerned about tax implications can stay in their positions and offset the risk involved in staying in the stocks, where if your stocks lose, you make money on the index futures from betting that they will go down.

While oil may not get back to $60 a barrel for a while, it’s more likely to get closer to that than not as our economic recovery continues, and it might not be too late to cash in on this move.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.