Negative Oil Prices: They Didn't Have to Happen!
Updated: Aug 19, 2021
May 14, 2020
If you needed any further confirmation that markets aren’t always rational, one need look no further that the crazy price action in the crude oil market on April 20th. As is by now well known, the NYMEX May crude oil futures contract on its penultimate day of trading settled at negative $37.63, down a staggering $55.90 from the previous day’s close. This was unprecedented in the long history of exchange traded physically delivered commodity futures (PDCF) trading and a perfect reflection of our unsettled times.
Of course, the financial press seized upon the story, focusing on the quirky and dangerous nature of physical commodity markets and the gross supply/demand imbalance present at the time. It was a unique situation and a great story. However, extremely imbalanced supply/demand situations have happened before and yet have never resulted in negative prices. Why was this situation different? The answer is surprising and not obvious.
To begin, technical and fundamental factors provided the perfect setup:
1. Extreme volatility going into the expiration of the May contract was predictable and to be expected. Extreme volatility resulting from the front month futures contract expiration is not unprecedented and is to be expected. The risk of overstaying your welcome is well known among professional futures traders. In this case, the potential for extreme volatility was telegraphed in advance and plain to see. Open interest of the May contract was an historically very high 105,593 contracts going into April 20th. This was considerably higher than the penultimate day open interest of 65,171 and 49,517 contracts in the previous April and March crudes contracts. Coupled with tremendous bearish technical developments, including closing the previous two trading days under critical and major historical support of $20.00 and in 18-year low ground, this was obviously an explosive situation.
2. At the same time, traders were understandably nervous about the global COVID-19 pandemic, it’s effect on other markets, and specifically the extreme supply/demand imbalance present in the crude oil market. It was widely reported at the time that storage was virtually full and unavailable, even in unconventional sources such as tankers. This understates the situation, as the supply/demand imbalance was the greatest since the Great Depression when crude oil was reported to have traded down to $0.11 cents in 1931. Given the situation, price action close to zero was certainly possible and had historical precedent. It should have come as no shock that the market was under extreme pressure.
Most commentators have focused only on the above two factors. But volatility and supply/demand imbalances only tell part of the story. What was the tipping point that thrust the contract into negative territory?
Playing a starring role were ineffective and misdirected communications from both the CME and certain FCMs. Very limited documentary evidence pertaining to negative futures prices can be found searching the CME website. On October 13, 2010, a notice directed at software developers indicated that programing for negative outright futures functionality existed. About ten years later, an announcement on April 3rd, 2020 to IT and back office personnel indicated that CME operations would support negative prices. On April 5th 2020, a memo addressed to Clearing Member Firms, CFOs and Back Office Managers was released announcing a “CME Clearing Plan to Address the Potential (Italics and bold added) of a Negative Underlying …in certain Energy futures contracts.” These announcements were technical in nature and generally directed at back offices. It was only on April 15, 2020 that the CME announced to “All Clearing Members” that NYMEX energy futures contracts could trade negative and settle below zero. Searching both the CME and CFTC website did not produce any indication that the CME had ever requested or received CFTC approval allowing negative prices for PDFC. Even after the announcements, the official Low Limit of $0.01 for all crude contracts was still indicated on the CME website.
Most traders only became aware of the possibility of negative crude futures via the startling intraday CME announcement at 1:10 PM on April 20, as crude had already traded to life-of-trading lows just above $4.00 and what was already very likely the greatest daily percentage decline in modern commodity trading history. The announcement was a bombshell and was remarkably reminiscent of the famous quote from Dr. Strangelove: “The whole point of building a doomsday machine is lost if you keep it a secret!” Indeed, up until then, it hadn’t occurred to most traders that negative prices were even possible. The plunge into negative territory was then preordained and the crazy slide to the low of the day at -$40.32 soon followed. Given the situation, a short-term trading halt or the limiting of trading in the May crude contract to liquidation only would have restored order. Some semblance of order was restored on April 21st with May crude’s final settlement of $10.01, albeit up an absurd $47.64 on the day.
Some FCMs contributed to the situation. Reports that certain FCM systems could not handle negative prices and incorrectly margined customers are interesting but to be expected given this unique situation. What is more concerning is that small retail customers were allowed to trade so near to expiration and under such explosive conditions. Clearly, the May contract had the potential for volatility that even industry veterans would find challenging. Bluntly, small, retail traders had no business being in the May contract at that time and should have been prohibited from trading by their FCM, the CME, and/or the CFTC. This would have avoided a financial effect on futures traders due to the allowance of negative prices that we conservatively estimate in the $3.8 billion range.
Some commentators have noted that the market did indeed perform its price discovery function, just at negative prices. However, physically delivered commodities don’t trade in a vacuum; rather, they trade in federally regulated markets and exchanges that must maintain their long-term viability. This requires orderly trading, preserving the sanctity of the delivery mechanism and the convergence of futures and cash prices at expiration, and assuring industry participants that the market is legitimate and well run. The trading on April 20 and the negative settlement of $37.63 violated and negated all of these factors.
All this leads to the inevitable conclusion that the economic absurdity and the unnecessary financial damage caused by allowing negative prices of crude futures (or any PDFC for that matter) could and should have been avoided.
Brett Friedman is a Partner at Winhall Risk Analytics, a risk management advisory firm that specializes in trade forensics as well as market and credit risk assessment and m