Telemus Special Market Commentary: Oil Woes

The price of West Texas Intermediate crude oil moved to an unprecedented levels and in a magnitude we would have not imagined. Crude oil had closed at $18.14 a barrel on Friday April 17th. By 5:00pmET on April 20th, the price had turned negative and an investor was being paid nearly $13 to take delivery on a barrel of oil.

In order to set the stage in describing what happened with the price of oil on Monday, it’s important to understand how the quoted price of oil is derived. The quoted price is based off the current West Texas Intermediate (WTI) crude oil futures contract. These contracts have monthly expirations, with the nearest monthly expiration serving as the ‘active’ contract that the quoted price of oil is based on.

The current active contract is the May contract. It is titled the May contract because it requires anyone holding the contract at expiration to take physical delivery of the commodity during the month of May. Since most investors don’t want to be responsible for transporting and storing oil, they will almost always sell out of the futures contract before it expires.

In actuality, trading in the active contract stops anywhere between the 21st and 23rd of the month prior to the month delivery occurs. For the May 2020 contract, trading stops on April 21st. The timing of the expiration on the May contract is what drove the unusual market dynamics in yesterday’s trading session.

With the current contract set to expire, those investors not wanting to take physical possession of oil needed to ‘roll’ the contract. This entailed selling the May contract and buying the June. Market speculation was that there were one or two large funds that had sizable positions in the active contract. The need for large investors to be forced sellers of the contract was a reasonable explanation for the nosedive in the price of oil.

While we found the dislocation in the oil market to be of interest, the structure of the market made it impractical to take advantage of this dislocation. To do so, an investor would have had to take physical possession of barrels of oil. This structural nuance limited investors’ ability to arbitrage the price gap between the May and June contracts

Our expectation is that when the June contract becomes the active contract during the trading day on April 21st, the price of oil will go back to somewhere in the $20’s. This is based on pricing in the WTI forward curve. Similar to a yield curve for bonds, the forward curve plots the current trading price on contracts out into the future. The table below shows the pricing of the forward curve.

                                               *Source: Bloomberg. Prices as of 5:00pmET WTI futures close

As you can see, the June contract is priced at $21/barrel with the July contract even higher at $27. Given the steepness in the curve, and the fact that the most severe price action occurred in the May contract, we view today’s oil price drop as solely a function of unusual market dynamics and not a broader issue with the commodity.

There is likely to be a glut of oil supply in the near term as production levels are slow to decline, while demand drops immediately. Near-term oil prices are likely to remain depressed at levels in the $20-30/barrel range. Long-term, the supply/demand dynamics will work through the market and we’d expect prices to be higher once an equilibrium is reached.