Guest post by The Duomo Initiative.
If there’s one thing we’ve learned recently, it’s that some things which start off small and local can become a global problem very quickly. With that in mind, it shouldn’t surprise you when I say that a small town in Oklahoma with a population of fewer than 8,000 was the epicentre of a seismic financial event that took place in April and is looming yet again this month.
Cushing might be a small town, but it plays a critical role in North America’s benchmark oil, West Texas Intermediate. Yes, that’s the one you may have heard about experiencing negative prices last month. The WTI futures contract for May hit an unbelievable low of minus $40 per barrel.
Why Cushing?
Cushing became a major focal point in the US oil market due to its strategic location, which is home to 24 pipelines connecting oil-producing locations (such as Canada, Texas & Oklahoma) to refining regions along the Gulf Coast and in the Midwest.
This pipeline crossroad is also home to 15 storage terminals, which have a working storage capacity of 76 million barrels of crude oil.
As a financial trader, why does this matter?
The New York Mercantile Exchange, also known as NYMEX, is the most liquid exchange for WTI futures contracts with daily volumes equivalent to 1.2 billion barrels of oil traded daily. If you’re trading WTI futures, they’re likely to be on the NYMEX.
Since these contracts are not cash-settled, that means if you’re holding a buy-contract at expiry, you would be expected to take physical delivery of oil. Due to its strategic position, Cushing serves as the delivery and settlement point for those NYMEX contracts.
As you can imagine though, not everyone trading these contracts is going to want to take physical delivery. In fact, less than 1% of the contracts actually make it to physical delivery.
In normal times, this isn’t usually much of a problem. In order to offset your buy-contract, you can sell a contract to cancel it out, therefore avoiding physical delivery and locking in the profit or loss at expiry.
What happened in April?
As you can imagine, demand for oil took a major hit in March and April as the world came to a virtual standstill. However, oil producers were still pumping and this meant the storage facilities at Cushing began to fill up with nowhere for the oil to go.
As buyers in the market started to dry up, traders were left holding their buy-contracts with no way of offsetting their positions. With each contract being worth 1,000 barrels of oil, they were keen to not take physical delivery.
This situation began to cause a panic as traders desperately attempted to offload their futures contracts with a May delivery. Essentially, without significant demand, traders were having to pay to have the contracts taken off their hands. This led to the price plummeting to the low of minus $40 a barrel.
What happens now?
The WTI futures market is not typically a popular choice for retail traders and investors, compared to more accessible markets like stocks. This is partly due to the large trading sizes, along with a lack of in-depth knowledge. However, this event has caused WTI futures to explode onto peoples radars and retail traders have been increasingly looking to get in on the action.
By not understanding the market properly, traders who get involved could be playing a very dangerous game. Not least of all by the hefty costs involved if they fail to be able to take physical delivery and are left with the hot potato towards the end of the contract.
In fact, a number of brokers are banning clients with less than $5 million in their account from trading oil futures to protect them this month and potentially into the near future. This should avoid horror stories like the one reported this week of a trader who started the day with $77k cash and finished the day with a debt of $9 million.
An alternative for traders looking to get involved would be to use contracts on the Intercontinental Exchange. The price is still based on the NYMEX futures but they are cash-settled, which removes the risk of physical delivery. NYMEX also offer E-minis based on the futures that are also cash-settled, as well as options contracts.
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Copyright 2020 by the Duomo Initiative.
Reprinted with permission. Source: https://www.duomoinitiative.com/blog/how-wti-oil-became-a-game-of-hot-potato
