A month after April 2020, when oil futures traded negative for the first time in history, markets are still wary, although they do not expect another round of negative prices. The recent developments are stress-testing our systems, which have been failing miserably. Clearly, our existing systems, models, business practices, and risk management approaches need to be transformed to respond to the new stressors.
The negative oil futures situation was precipitated after the May contract for West Texas Intermediate (WTI) closed at (-)USD 37.63 on April 20, a day prior to expiry. Underlying factors, such as low demand, specifically on account of the COVID-19 crisis, combined with oversupply, contributed to the weakness in oil prices. However, the major reason for negative prices was the fact that storage facilities at the delivery point in Cushing, Oklahoma, were nearly full. Buyers of contracts, who were obligated to take physical delivery of oil, had to offload their contracts to avoid huge storage costs, resulting in the negative prices.
Negative futures prices have occurred in the past too, as in the case of electric energy. However, such developments have been for short periods, and mainly due to a mismatch between demand and supply. Recently, we have also seen interest rates becoming negative in some countries; these, however, are determined by central banks to a large extent.
Nonetheless, it is disconcerting that the most traded commodity futures in the world should enter the negative price territory. Just try to imagine Apple stock trading negative!
As one would expect, the negative prices have impacted different players in the financial industry, including exchanges and regulators, index and ETF providers, brokerages and investors, as well as risk management practices across the board.
Exchanges and Regulators
Following the oil price meltdown, requests for probe into market manipulation and system failure have been raised by the Bank of China and Continental Resources. On April 8, 2020, the Chicago Mercantile Exchange (CME) issued a circular on changes in its systems to accommodate negative prices, and further confirmed on April 15, 2020, that “certain NYMEX energy futures contracts could trade at negative or zero trade prices or be settled at negative or zero values.” The CME is of the view that futures markets have traded in an efficient manner to reflect the fundamentals. Also, other energy contracts, such as heating oil or natural gas, are being modified for possible negative prices.
However, things have been messy in some places. For example, in India, the largest commodity exchange, MCX, which has oil contracts tracking NYMEX, was unprepared. Its trading systems or risk management systems were not designed to handle negative prices. The MCX had initially announced a provisional settlement price of INR 1 which was later on revised to (-) INR 2,884 per barrel.. This has resulted in many litigations against the exchange and regulator SEBI by affected parties. The learning for exchanges and regulators is to ensure robust contracts, communications and trading systems, and margin and risk management mechanisms.
Almost one month after the negative prices, the mood at exchanges remains cautious. The US Commodity Futures Trading Commission has issued a warning to exchanges and brokerages, telling them that they need to protect markets and customers from manipulation. Many brokerages have now restricted customers from buying new positions in crude contracts. The CME has raised maintenance margins for June contracts by 20% and has ordered the United States Oil Fund LP (USO.P), the largest oil-focused exchange-traded product in the US, to limit its position in the June contract to no more than 10,000 lots. Consequently, open interest in June has declined substantially.
Index and ETF Providers
For ETF providers with commodity ETFs, the negative prices have posed a big challenge. The United States Oil Fund (USO), the world’s largest oil ETF, had passively tracked the front month futures in the past. On April 17, it announced a revision in holdings pattern to 80% in the front month and 20% in the second month. Subsequently, it announced several revisions in its holding pattern. The ETF has become more of an actively managed fund, rather than a passive one in response to the abnormality in oil prices.
Similar changes were announced by Samsung Asset Management in Asia and other US oil ETFs. In some cases, the creation of new units has been suspended temporarily. Moreover, there has been the emergence of a ‘Super Contango’ where the longer-dated futures trade much higher compared with spot. This will result in losses for ETF investors, as ETFs will have to roll over at higher prices. Whatever be the product, ETF providers who use derivatives will need to be on guard, even if they use a passively managed strategy. They would also need to reassess their fund prospectus and investor communication.
In light of the current market situation, commodity index providers, such as Bloomberg and S&P Dow Jones Indices, have announced plans to roll over into longer-dated oil contracts, as opposed to the regular practice of next-month-roll. Rolling in advance, several weeks prior to expiry, has been a prudent practice among commodity indexes. Index providers, specifically those with embedded derivatives, might have to relook at their existing models, index methodologies, and calculations, to assess if any change is needed.
Brokerages and Investors
Brokerages were one of the most financially affected when oil prices plunged below zero. The NASDAQ- listed Interactive Brokers LLC had to take a loss of USD 104 mn to compensate for margin calls incurred by customers due to the negative prices. The company’s trading systems were not configured for negative prices, because of which customers were not able to trade when the prices went negative. Similar instances were seen in India and China, where some brokerages incurred huge losses. There is a chance that these losses might wipe away a substantial part of company capital, especially for those with highly leveraged business models.
It is estimated that retail investors linked to a structured product issued by the Bank of China lost USD 1.3 bn following the negative oil features. CME Chief Terry Duffy (CEO) has commented, “The small retail investors are somebody that we do not target.” Investors and academics might want to revisit the premise of commodities as a financial asset. The financialization of commodities through ETFs and other products over the last two decades has come full circle. Brokerages / investors will need to become more aware and only promote or trade products that they completely understand or those suited to their risk profile.
Risk management and derivative pricing models need to be recalibrated to include the possibility of negative prices. Similar challenges were witnessed when interest rates became negative in the recent past. The CME has replaced the popular Black-Scholes derivatives pricing model with the Bachelier model, which can accommodate negative asset prices.
Banks that lend to commodity trading / producer firms, or create structured commodity derivative-based products will need to upgrade their risk management systems with robust stress testing / scenario analysis. They might also need to incorporate additional hedges and modify their contract terms. Predictive modeling of prices using techniques, such as AI / ML can help flag the possibility of low / negative price levels in advance.
It is time the financial industry prepares for the next round of uncertainty.