Futures contract expiration days can be plenty interesting, and a lot of money can be made, but Monday’s May WTI oil futures trading took us into another universe.
A lot of money is made and lost trading oil futures, and there are some epic stories out there already, big traders who got caught on the wrong side of the market and ended up getting completely hammered. Trading oil can be very tricky at times, especially when traders chain themselves to their positions and get taken down to the bottom of the sea.
What happened with West Texas Intermediate May contract futures are from another world altogether, where they actually went way below water and got the bens, a once in a lifetime event that may not happen again ever.
We saw May WTI break $20 last week, and even dip below $18 for a time, where it settled in for the weekend. Monday was expiration day though, and given the massive glut out there right now, we knew that we were in for some real fireworks. No one expected the contract to completely blow up like it did though, and blowing up isn’t even a term that seems anywhere strong enough to describe this.
Shock and awe wouldn’t be enough either, and we’re going to have to come up with a new phrase to describe what happens when you lose all $18 that a futures contract is worth, and for a time, $40 more. It’s hard for a lot of people to even make sense of how a futures contract could trade at $40 in the hole, or in the hole at all, but the stars ended up aligning enough in the oil market to make such a bizarre event actually happen.
In order to start to understand this, and especially how we could see oil so far underwater and then back to being over $20 a barrel in the aftermath with the next go-around, we need to know a little about how futures trading works. This event also produces a once in a lifetime opportunity to see the mechanism of futures portrayed in such an extreme measure to make concepts that may not be that easy to understand for a lot of people much more transparent, like how the spot price ultimately determines what these contracts are worth.
That’s actually a good place to start, to talk a little about how what goes on with futures trading does not affect spot prices, as futures and spot prices will always converge at expiration. Spot prices are not normally in the negative, but when they are, this can cause some pretty strange things indeed, even as strange as paying someone $40 per barrel to take it off your hands.
It’s not all that hard to understand how this could happen in the spot market, and why this actually did happen. While we are reading elsewhere about the oversupply from our big economic slowdown caused futures to go this far into the negative, this still doesn’t tell us that much about how such a bizarre event such as oil futures trading this negative could happen.
Even if you don’t trade futures, it is good to have a better idea than that how this could happen and why it did, and why the stock market wasn’t too worried about all this, even though as it turns out they should be more worried than they are. Even if we only trade stocks, knowing that the risk from this is far from over can be helpful to prepare us for if this has more of an effect upon them than this appears to involve to many.
The biggest offshoot of this is that we may be in a lot more trouble economically than we currently realize. The stock market worries when the price of oil goes down, and if something like this doesn’t concern them, with the spot price being so absurdly in the negative now, nothing will. This may not last that long but it shows us that the canary in our economic mine is not just sick right now but has just died. There has to be more corpses out there, more than we are expecting.
Sure, the June WTI contract last traded over $22 a barrel on Monday, the one that will become the nearest expiring contract on Tuesday, and if you just look at that, things look pretty normal because that’s in the range of where WTI futures have been trading at lately anyway. Things are very far from normal now though, and we do want to be somewhat concerned that we have spot prices now in the United States that are as low as -$48 a barrel.
We are hearing about situations where producers are dumping things like milk and beer, because they can neither sell it or store it, and they have to do something with it. You can’t do that with millions of barrels of oil, and if you have a lot that you can’t sell or store, you have to do something with it, even if this means paying someone a lot of money to take if off your hands.
This is exactly what is happening in the spot market in some areas of the United States right now. This is what caused such a weird phenomenon happen with May WTI, which, on its final day of trading, saw its prices converge with the spot market as these things do, with the spot market being that far below water. By the time the clock struck midnight on this contract, at 2:30 PM ET on Monday, WTI futures dropped all the way to -$40.
This was not done on a lot of volume though, and it’s not as if the oil market went this low, it was rather the contracts that were set to be settled, and futures contracts always settle right around the spot price. When you realize that this is a contract to buy or sell oil at expiration, and this is the price that it brings on the spot market, you aren’t going to want to pay more than the going rate, or sell it for less than that, because you could just trade it on the spot market otherwise if it was to your advantage.
There has to be some advantage for people to trade, and make no mistake about it, there was a phenomenal amount of money made as well as lost on this day in WTI futures. It opened down after the weekend, at $15.63, and just kept going down all day, to zero, and then much lower than that as the selling climaxed at the appointed closing hour.
For Every Dollar Lost with Futures, One is Made, and a Lot of Money Changed Hands Monday
To some, this might sound like a lot of people lost a whole lot of money, their whole investment and a lot more perhaps, but futures trading is nothing like buying a stock at $15 and then seeing it lose all its value. With stocks, you buy it from someone, and if it did go to zero, you lost the $15, all your money, instead of the previous owner had they held it. Some people are indeed foolish enough to want to ride their stocks down all the way, but futures traders cannot do that even if they wanted, because these are leveraged trades and they would get closed out far before they lost anywhere near this much.
Monday’s battle was between the traders and the oil consumers mostly, and the oil consumers got massacred while the traders enjoyed the mind-boggling spoils. It’s worth having a little look at what was possible trading this contract on this day, which will certainly blow the minds of investors who hope for returns like 20% per year.
No one really expected a move anywhere near this big, but we knew that there was a big glut in supply, and some extremely serious storage issues. Put that together with this being contract expiration day, and the shadow of the bear on the horizon on the opening of this day appeared as a mountain. This was not a day to be a bull unless you were completely out of your mind, and even bad traders aren’t that crazy.
We go on the short side of some contracts at the open for $15, we’ll say. This is on Sunday night, but the ride that is likely in store for us is as worth staying up all night as anything could ever be, and we can sleep the next afternoon. Maybe we aren’t up for this and wait until early Monday morning when the price is around $12, and this might not seem like much of a difference, but it sure is with futures trading.
The night’s sleep would have actually cost us a lot of money actually. We’re leveraged 6 times with this, so that $3 now becomes $18, and that means that we’ve lost over 100% return while in bed. That’s a lot to pay, but no matter, we were up for it, and we’re up this much by the time we hear the roosters crow. Those who did wait for the rooster still had plenty to crow about though, and unbelievable amount in fact.
We hold it right until close to the bell, and we didn’t want to be too greedy or push our luck too far, so we got out at -$35. Now it’s time to count up the money, and we just made a return of 2000% in less than a day. That’s a hundred years’ worth of 20% a year, although we probably won’t see anything like this or close in 100 years, or maybe ever, at this would involve oil moving $55 a barrel in just one day again.
Trading oil futures is not for the feint of heart normally, but when you see something drop this much, this steadily, and this fast, the only thing happening with your heart is it continued to leap as you watched these massive gains unfold without any need to think. There were, no doubt, plenty of traders who got anxious and sold too soon, as traders often do, but this was the ultimate lesson in the benefits of letting your profits run, and this was like being at a poker game where you could see everyone’s cards and they all had loads of money to lose to you.
Your kids could have traded this contract on this day, that’s how easy it was. All you had to tell them is to hold as long as it goes down, set them up with a chart, and tell them to watch it. Red bars ran the table while green bars completely took the day off.
We now want to turn to looking more into how something like this could happen, which requires us to have a look at how futures trading actually works in a little more depth. We will often read that futures markets are a battle between primary participants, in this case the oil producers and consumers, and speculators, those who just trade the futures and have no intention of ever trading in oil itself.
Primary participants have always complained that who they call speculators run the price up with commodities, and while they certainly can, as primaries certainly can as well, none of this affects the price of oil itself, because the price of oil at the end of the contract will always determine the price. Spot prices are completely based upon the supply and demand of the commodities that are traded, and if anyone had any doubt about this, they sure got a lesson Monday.
Futures trading is pure speculation though no matter who is doing it. Primaries don’t always want us to realize this because they want the speculation to themselves, and many don’t realize that having traders along for the ride helps these markets by providing even more liquidity, which keeps spreads lower than they would be if all you had is big players involved.
That doesn’t matter because we can’t just shut the traders out anyway, and if primaries really want that kind of market, they can go with what is called the forward market instead, which is basically futures traded privately among themselves. They do trade forwards, but also like publicly traded futures as well, by virtue of their high participation level, and if you allow something to be traded publicly, the public will be in the game by definition.
Futures Trades are Just Wagers on Future Prices, and Not What the Things Are Worth Now
Since futures are derivatives, they just consist of bets on the future price of an asset, no matter who is making them, and both primaries and traders bet alongside of each other in this game. There is no long or short in the same way as we have with stocks for instance, as every trade involves a direct bet on either side, with one side betting the price will go up and the other betting that it will go down.
Primary participants have other interests besides winning bets, and futures betting from that side of the table involves trying to hedge, not make a profit, although some of these primary participants do look to do some trading as well. This actually puts the primaries at a distinct disadvantage, as they care where the price ends up and are also much more committed to their trades, where traders are just looking to make money and don’t care where oil ends up in the end when these contracts become due.
We might think that the oil companies got clobbered Monday, but nothing could be further from the truth, as their bets were on the same side as the traders who made all that easy money. They made a lot more in fact. If you bought contracts to sell oil back when it was $40, that means you will get $40 a barrel now, even though the price of the contracts sank to the bottom of the sea.
They surely hung on to these, and like stocks, a lot of these contracts are not in play, just like most of the stock in a company is not in play at any given time on the stock market. Oil companies do this to lock in prices for their oil in the future, which allows them to run their businesses with more certainty.
Getting paid $40 a barrel instead of paying someone that much to take it off your hands is obviously a huge benefit to oil producers. Oil consumers take the other side of these contracts and agree to buy it for that amount, and having to pay $40 a barrel instead of getting paid $40 and get the oil as well is unspeakably bad, and they were the real losers Monday, even though they were running for their lives from this mountain sized bear throughout the day.
The reason why they are not as eager to hold these contracts is that they have to make up the difference between the price they paid for the contract and what it ended up being worth, and as prices plummet, their losses plummet proportionately. This is what really caused Monday’s explosion, and the words panic and dump are appropriate here, a massive panic and dump that is.
We might think that they should have seen this coming, and bailed as soon as we started locking things down, but that would have just crashed things sooner, even though it would have been spread out more and of a lesser magnitude. It would have been plenty big anyway, and this was a case of being so far behind that any sense you may have had becomes overwhelmed, the same thing that happens in the horror stories of commodity traders losing massive amounts of money while still in their positions and may not feel that they have much more to lose than their financial lives.
Some might think that we need more regulation after this spectacle, perhaps putting in curbs, but you can’t do that with expiring futures contracts. We will end up in the same place anyway, whether it was Monday or Tuesday, as once again, we are on a collision course with spot prices at expiration, and it was the spot prices that caused all of this.
We actually saw the price of this contract rise a little above zero after trading concluded, which might seem the strangest thing of all, but this is due to the effect of the contracts being settled. This is like someone hauling away the bodies after a battle, and since time is up, we need to clean whatever mess is left, even though it’s so weird to have this much carnage. A lot of this just gets pushed forward, rolled over as they call it, although at a huge disadvantage of course with loads of money changing hands to settle the score.
As the prices move during the life of a futures contract, this does not actually represent the value of the asset at any point in time, it instead reflects the current belief of what the price will be at expiration. This is a lot like having a stock worth many times what the company is worth, and people bid up stocks just like they do futures, with a view to the future, only without a clock.
We need a clock with futures because this is primarily about exchanging commodities, and there has to be a time where either the commodity is delivered or a cash payment equal to the difference changes hands.
The June contract is now at the front of the line, and it’s around $22, while oil is being sold at minus $45 or lower in the real world, if we can even call that selling. Going long the June contract here is a big bet that this supply glut will really lessen in just a month, and even though there’s a long way to go price wise, this is already where most of the action has been for a while, where there’s a whole month left to speculate with.
Welcome to the hectic world of oil futures trading, which has taken on a weirdness that is even hard to imagine now. While we may never see anything close to this again, as long as we continue to pump as much as we do and have nowhere good to put it, it’s hard to imagine this situation stabilizing in just a month, even to the point where we can hold $20 with this contract. Get ready for more craziness, not like this, but plenty crazy enough, and plenty lucrative if you are up for it.