Just when we thought that Central Banks’ trillions of fresh money off the printing press had stabilized the financial markets, the price of May WTI Crude oil fell to -$40 a barrel on Monday. The proximate cause was the excess supply of oil and no storage for the oil glut in Cushing Oklahoma. The afternoon announcement by the CME that negative oil futures prices were allowed accelerated the selloff of the contract to that unthinkable intraday level of -$40 per barrel (Source: Bloomberg). Not unlike the XIV debacle of early 2018, could this portend the implosion of derivatives based oil ETFs?
One contract of oil futures buys 1000 barrels of oil, so what a negative price of $-40 means is that one could theoretically receive the rights to 1000 barrels of oil and at the same time receive a payment of $40,000. Converting this to gallons, one could receive approximately 42,000 gallons of crude oil and get paid $40,000 in addition to the oil! Think about that – for each gallon of crude oil you could get the crude oil and also get a dollar, only if you could officially store it somewhere.
Lest one jump up and down and say this is crazy, know that this is not the first time that we have gotten used to paying for the privilege of parting with something of value. In the case of oil, the culprit has been the incredible oversupply, combined with little spare storage in the face of a decimation of demand connected with the sudden COVID-19 economic stop. However, in Europe and Japan, bond yields have been negative for a few years now, and investors have been already willingly parting with cash and paying for the privilege for doing so. This “normalcy of deviance” is becoming all too common now across many asset classes. The excess supply of liquidity drove bond yields below zero. The excess supply of oil has driven its price below zero.
Could these two disparate facts, one from the real economy (oil), and the other from the paper financial economy (bond markets) be connected?
I think that not only are they deeply connected, but they carry signs of stranger things to follow, and the way this story unfolds will likely not be pretty for retail investors in derivatives based ETFs that are the crack cocaine of passive investing.
To understand the evolution of where we are today, we have to look back not just twenty years, but perhaps the last century. Following the great depression of the 1930s, governments engaged in an unprecedented drive to increase production so that economic security via consistently high employment could be guaranteed. As production for production’s sake became paramount in the US economy, the goods that were produced had to be consumed. In the words of John Kenneth Galbraith (“The Affluent Society”), where there were no needs, needs had to be manufactured via marketing and advertising of products that were graduated from luxuries to necessities. In order to enable consumption for those who could not comfortably purchase the goods, borrowing had to be made easy and affordable.
As borrowing became easy, an enormous amount of debt was created and securitized. This debt explosion has resulted in debt-driven booms and busts, or the credit cycle, as witnessed by the global financial crisis of 2008-2009 and more recently the sudden and sharp deleveraging of March 2020. And the debt debacles have been solved with more debt. The Fed stepped in this last time, promising to backstop corporate and junk credit. Perhaps the negative-returning financial and real assets are the natural endgame of decades of accumulated leverage and a glut of money and credit.
So how does cheap money and leverage relate to the negative price of oil?
In a debt driven market, everything is financialized to generate total returns. Total returns depend on returns from increasing prices and also from “carry” or yield. In the energy markets, financial market participants can create a synthetic “refinery” by buying crude oil futures, and selling refined product futures, such as gasoline or heating oil. They can also play the backwardation, i.e. sell a contract closer to maturity, and buy one further out, or contango, which does the reverse. This, of course, is not a free lunch. When there is a supply shock the commodity curve becomes more backwardated, and when there is a demand shock, like we are seeing now, the curve becomes more steep or super-contangoed. While twenty years ago these curve trades were done via OTC (“over the counter”) swap arrangements limited to professionals, today the democratized access to the futures markets makes building a synthetic refinery, or trading the curve as simple as opening a futures account. A futures account, or an ETF based on futures can be highly leveraged, since the futures contracts are highly leveraged.
Futures based synthetic products such as ETFs and ETNs make the speculative access to the derivatives markets convenient for retail investors. For example, the US Oil Fund (USO) is a fund that provides exposure to the oil market in an exchange traded form, but uses futures contracts as its underlying holdings. When new fund shares are created, the fund has to buy futures contracts. As the fund rolls futures contracts forward, for instance selling the May contract to buy the June contract, it does so in a fairly price insensitive way. This is of course by design, and follows the prospectus underlying the product that anyone can read. The true risk to the fund’s agents is not a price collapse, but the legal risk from not executing on the terms specified in the prospectus.
Two years ago the inverse VIX ETN (XIV) which was also an agent implementing short volatility trades, spectacularly imploded when volatility spiked. The fund, which was based on shorting VIX futures contracts, had to buy them in the market, thus setting off a cycle where it devoured itself and many of its peers.
Get the gist? In a financial economy we have subtly evolved from consuming real products to financial products that are being produced to satisfy the speculative demand of investors. The lower the yield on traditional investments, the more the need to lever up products and make them available to retail investors. This author anticipated the debacle in the VIX ETP market, but did not expect its collateral damage to show up in something as real as the oil market.
What the COVID disaster and sudden economic shock has done is to expose the embedded widespread vulnerability of a highly levered financial system with products created to sate the need for return. On the surface the fact that the price of oil went negative seems to only reflect the fact that there is no storage for oil at any price. However, the fact that financial futures contracts on oil went so far below the cost of storage tells us that the constraints and leverage created by the commoditized financial system has amplified these frictions to unthinkable levels.
The mantra to remember as the levered financial system unravels under repeated shocks is that “anything can happen” and no “price is sacred”. First bond yields, then the VIX, and now oil. What financial asset’s value will go negative next? In this unraveling world of leverage, no asset class or security is safe. For investors this is a sobering thought indeed.
Author’s Update as of Wednesday April 22, 2020:
Subsequent to the article above, The USO ETF changed its structure to now look more like an actively managed exchange traded discretionary hedge fund than a passive, rules based vehicle. As per the disclosures (Source: www.uscfinvestments.com/uso), commencing on April 22, 2020, USO may invest in NYMEX or ICE Futures in any month available or in varying percentages or in any other permitted investments in its prospectus without further disclosure.
In other news, VelocityShares Daily 3x Inverse Crude ETN (DWTIF) was de-listed. Note that the XIV ETF mentioned above (Daily Inverse VIX Short-Term ETN) was liquidated in 2018 when the VIX spiked (Source: Bloomberg).