By Sean Field and Mette M. High
When the COVID-19 pandemic struck, demand for crude oil fell suddenly. The price of West Texas Intermediate (WTI) oil dropped sharply as buyers for the US light sweet crude dwindled and crude oil storage facilities in places such as Cushing, Oklahoma, quickly filled up with excess supply. The pandemic exposed the logistics and storage constraints of the US landlocked oil infrastructure that was oversupplied by domestic and imported crude – an infrastructure that is generally less able to deal with sudden fluxes in demand and supply compared to its European, sea-borne rival Brent (see parts 1 and 2 of this series).
Yet it was still unexpected when the price of WTI on 20 April 2020 plummeted into the negative for the first time in history, reaching –US $37.63. The answer as to why the price dipped so low and so fast has partially to do with WTI’s physical dimensions and partly to do with how it is traded. While a glut of oil on global markets depressed the price of WTI, it was the trading on the futures market that was responsible for plunging its price into the negative. This event raises fundamental questions about how oil is valued, by whom, and for what purpose.
In this series, we share a few thoughts that struck us after negative oil prices became not just a possibility, but a reality. In this part 3, we discuss the financial market for WTI and how it contributed to the unprecedented price drop.
Multiple Oil Markets
WTI is traded in multiple markets at once. Buyers and sellers can trade it on the ‘spot’ market and ‘futures’ markets. The spot market is where oil is physically traded, and spot price refers to the current value of a physical barrel of oil at that particular moment in time. Spot prices have historically represented buyers’ and sellers’ (who have the capital to buy and sell oil) perceptions of prevailing current crude oil production and consumption conditions, including market stability. Because crude oil is spot traded at various locations throughout the United States, the spot price of WTI differs based on where it is traded. But these prices are all tied to the spot price of WTI at Cushing, trading either at a discount or premium to the Cushing price.
The futures markets for WTI are where buyers and sellers trade contracts for future oil. Futures contracts exist for each month well into the future, meaning buyers and sellers can trade contracts for WTI that are set to expire next month and for every month up to early 2031! The price of these futures contracts represents buyers’ and sellers’ perceptions of future crude oil production and consumption conditions, as well as the price they are willing to speculatively exchange contracts for. The futures markets have become increasingly significant for how the oil industry fares in relation to volatile commodity prices. Oil producers who have sold their oil at futures prices can survive difficult times whereas those who have not will struggle and likely join the line of bankruptcies. However, at times when the spot price is high, those who have committed themselves to futures markets will miss the wave that the others are riding. Spot and futures markets have thus become crucial for how oil producers navigate the booms and busts of commodity trading.
Spot markets without federal price controls were created in 1981 when the US government removed what remained of Nixon-era price controls on US domestic crude oil and refined crude oil products. Shortly after, in 1983, the New York Mercantile Exchange (NYMEX) launched WTI futures contracts for trading. This combination ushered in a new age of free market financialization – WTI prices could rise and fall based on the market dynamics of supply and demand without government intervention, and oil could be traded and speculated on in both the spot and futures markets.
When the Chicago Mercantile Exchange bought NYMEX in 2008, these futures contracts were rebranded “CME –NYMEX” WTI futures contracts. CME is now the world’s largest financial derivatives exchange company and the CME-NYMEX WTI futures contract is the single most traded crude oil contract in the world. Producers, manufacturers, investors and speculators around the world use these futures contracts to invest in, hedge against, and speculate on US crude. Each CME-NYMEX WTI futures contract is for the equivalent of 1,000 barrels of oil, and contracts are traded 23 hours a day, six days a week, with prices fluctuating minute-to-minute based on buying and selling activity.
Having no physical storage, transport and production limitations, the futures markets for WTI are many times larger than the spot market. It is virtual trading and the only limit on how many futures contracts can be created is that for every buyer there must be a seller (and vice versa). The nature of WTI futures contracts on the CME-NYMEX trading system thus makes the futures markets effectively limitless.
Where the Future Meets the Material
The WTI contracts expire around the 20th day of each month (e.g. 20 April 2020), several days prior to the actual delivery of the barrels (e.g. May 2020). When WTI futures contracts expire, contract holders are obliged to physically exchange oil at Cushing. It is at this point of expiry that the price of the expiring futures contracts and the current spot price converge – merging the two prices into one.
WTI futures prices and spot prices fluctuate up and down. Price convergence holds futures market prices in tension with spot market prices and links the expiring contract price to the spot price at expiry. This is because as a futures contract expires, a promise to exchange oil becomes an obligation to physically exchange crude, and the prevailing price of physical crude is spot market price. As a futures contract approaches expiry and locks the counter-parties into imminent exchange, speculation on the value of this future oil fades into current spot price at expiry- which is dependent on physical crude supply, demand, and capacity constraints.
This physical delivery aspect of WTI futures contracts is a key factor that distinguishes it from Brent futures contracts. When Brent futures contracts expire, they are typically ‘cash settled’. There is an option for buyers and sellers of Brent futures to physically exchange oil, but it is not required (this is the subject of our next blog post in this series).
Cushing has long been a central delivery, storage and transportation hub for WTI (see part 2 of this series). However, it achieved a new level of importance after the creation of NYMEX futures contracts in 1983 because when these contracts expire, they result in the physical exchange of oil specifically at Cushing. It is at this moment, in this place, that the futures market is materially linked to the spot market. This may take the form of physically transferring oil via pipeline, rail or truck; or, alternatively, it can entail transferring ownership of oil within a storage facility at Cushing.
Yet, it is important to note that only about 1% of CME-NYMEX WTI Futures contracts actually result in physical exchange. Most present-day contract holders are merely interested in futures contracts as financial instruments, like mentioned earlier in the context of oil producers. Some ‘reverse out’ of their contracts before they expire. They do this by creating a contract to offset (i.e. cancel out) the contract they own – a contract to ‘buy’ oil can be cancelled out by creating a contract to ‘sell’ oil for the same month. Others ‘roll’ their contracts by ‘reversing out’ and buying contracts for the same commodity at a future date. These are tactics commonly used by a burgeoning number of financial investors who want to invest in oil but do not want to buy and sell physical barrels of WTI. These tactics enable the virtual and potentially ongoing, limitless trading in oil. But in order to ‘reverse out’ or ‘roll’, there must be a counterparty willing to make the exchange…
Futures, COVID and Cushing
On the 20 April 2020, which was the day that the May 2020 WTI futures contracts were set to expire, many traders still held contracts to buy oil. In the hours prior to expiry, these traders frantically tried to ‘reverse’ or ‘roll’ their contracts. In the middle of the COVID-19 pandemic, however, there were very few participants willing to be counterparties for these ‘reverses’ and ‘rolls’. These traders thus had to offer lower and lower priced sell contracts to ‘reverse out’ – effectively paying counterparties so they could avoid taking physical delivery of oil (see Fig. 3).
The option to take physical delivery might have been possible under other circumstances but because of the COVID-19 pandemic, storage at Cushing was scarce and very expensive. Some industry insiders have reported that it was actually fully leased and hence unavailable to others. At the peak of this storage crisis, an acquaintance we know half-jokingly tried to convince his wife to use their backyard swimming pool to store crude oil! Not only would it be an additional storage vessel, but also anyone with storage could fill it with cheap oil to sell later!
Reconciling the Financial Future with the Material Present
According to the US Energy Information Administration and industry insiders, few (if any) physical sellers actually paid buyers to take their oil. It was only futures market traders who paid counterparties to buy their oil contracts to ensure they did not have to take physical delivery, pushing the spot price of WTI into the negative as the expiring contract price and spot price converged.
Yet, this event has had very material consequences. For the people and communities that economically depend on oil production, the negative price spike exacerbated the crisis of over-production partly caused by the COVID-19 pandemic. At a time when the general political and investor climate encourages growth in the renewable energy sector, there have been many bankruptcies and widespread job losses across the oil industry. Inversely, inexpensive oil has made hydrocarbons a more cost-competitive source of energy by comparison with other forms of energy, such as renewables, to the chagrin of those advocating for a transition away from fossil fuels.
20 April demonstrates not only what can happen when fixed material oil infrastructure intersects with the virtual limitlessness of financial markets, but also the power of finance to shape our collective energy worlds. Circulating as financial objects to be materialized as oil in the future, futures contracts trade as virtual commodities alienated from the chemical composition, uses, and hazards of the substances they are based on. Moreover, these contracts are economically valued and traded at speeds determined by a relatively select group of financial experts working in the highly synthesized world of financial derivatives markets – a realm that is inaccessible and largely opaque to people outside these expert circles, but remains very much part of the world that we all inhabit.
This raises important questions about how and by what processes we assign economic value to things, especially vital commodities. At a time when our collective energy futures are being envisioned and publicly debated, it is crucial we consider carefully how modes of finance shape the value of these energy futures.
In part 4 of our series, we will discuss the futures and spot markets for Brent crude oil and how these differ from the WTI markets.