By Adam A. Rozencwajg, CFA, Managing Partner, Geohring & Rozencwajg

Oil prices joined bond yields in doing the unthinkable: trading at negative levels. In the case of oil, the West Texas Intermediate May 2020 contract reached a low of -$40.32 at 2:24 pm before rallying back to finish the day at -$15.92 per barrel. This marked the first time in history oil prices broke below zero. How could this have happened and what are the implications for crude markets in the short-, medium-, and long-term?

In short, last week’s bizarre action is a sign of how “paper” traders have come to dominate modern oil markets.

The NYMEX West Texas Intermediate is a physically settled oil futures contract and one of the two most important contracts in the world. Anyone long a WTI contract upon expiry must stand ready to take physical delivery of the crude. Conversely, anyone short must stand ready to deliver oil. Those traders not intending to take or deliver physical volumes often begin the process of reducing their exposure several days before the contract expires so as not to be caught offside. In general, a trader can either close the position outright by purchasing an offsetting contract, or “roll” their exposure by purchasing the offsetting position in the expiring contract and establishing a new position in the next month’s contract.

In recent years, the open interest from pure “paper” traders (those without the ability to transact in the physical commodity) has come to dwarf that of the physical traders by an order of magnitude. As a result, the vast majority of WTI contracts are netted out without any oil changing hands. At the same time, contract expiry has become a particularly volatile period in oil markets.

In the event a “paper” trader is left with a position into expiry, they must turn to a physical trader to take on their position. Normally, physical traders are willing to act as market makers during contract expiry, often resulting in substantial profits.

The May 2020 WTI contract expired last week, however two separate issues combined making the normal expiry process impossible. First, the amount of “paper” positions left open into expiry was much larger than in the past. Some 109,000 contracts were left open as of this morning compared with 3,200 a month prior and only 45 contracts two months ago. The reason for this remains unclear however some have pointed to the USO ETF that has seen large inflows in recent weeks requiring large purchases of WTI contracts.

At the same time, physical crude oil storage is nearly full due to the severe demand impacts of the COVID-19 response. Physical traders found themselves with little to no spare capacity, leaving them unable to purchase the remaining open futures contract.

The result was basically a short-squeeze in reverse: traders were forced to repeatedly reduce their offer price to try and find an able buyer. When no such buyer presented themselves, the price broke through zero with “trapped” longs offering to pay the “buyers” up to $45 per barrel to take the crude off their hands.

While this all sounds incredibly bearish, we should point out it is as much a function of how “financialized” the oil markets have become as it is a function of the underlying fundamentals. For example, Brent crude (the other major oil future contract) is not physically settled and so not subject to the same issues. As a result, Brent finished the day at $25.57 per barrel (BNO). Similarly, the WTI June 2020 contract (not impacted by today’s “squeeze”) finished the day at $20.43.

The short-term will continue to be dominated by severe COVID-19 related demand impacts. The threat of “full storage” looms as inventories continue to grow into the end of April and through May. However, while the very-short-term could be bleak, we believe it is likely already priced in. We remain much more interested in the medium and longer-term story which will be dominated by plummeting supply.

Current prices have already caused massive capital spending reductions while the shutting-in of existing producing wells is soon to come. Ultimately, inventories cannot push past “full,” and our models tell us that the supply impact will be so great that storage will start to draw at record levels as soon as demand normalizes. The entire oil market runs the risk of normalizing much faster than anyone realizes.