CONTANGO – MORE THAN MAXIMUM Whilst the negative prices were very difficult to understand, the extreme contango was also very challenging.
Chart 2 shows the WTI m2-m1 spread on a closing basis from May 2015- May 2020.
Typically, in a well-supplied market, the front month WTI (m1-m2) contango can be expected around 25cts to 50cts/bbl, and is almost always between $0 and $1/bbl.
Unlike ferrous metals, which can be stored in a field at very cheap rates thereby limiting the maximum contango, oil needs to be stored properly to avoid serious environmental issues, and the extreme contango was the price paid to avoid this problem.
The contango caused significant issues for some paper players, who found themselves in the twilight zone where derivatives become physical assets.
For example, the United States Oil Fund (USO) is an ETF allowing smaller investors a convenient route into holding a long oil position, with the price of the ETF reflecting the front month WTI contract plus costs.
Each month the ETF sells their nearby contract and buys the next prompt month, which involves paying the contango as a cost to roll the position.
Chart 2: WTI closing m2-m1, US$/bbI - May 2015 - May 2020
Originally mandated to hold front month futures, USO were reported to have held 25% of the May contract so would have been affected as the differential moved from the usual <$1/bbl out to a maximum of $60/bbl.
In the aftermath, USO revised its strategy, pushing its holding into forward months to avoid punishing contango losses when rolling its whole position m1 to m2, but USO aren’t the first oil market participants to learn the importance of relative market size when rolling nearby positions:
Back in the early 1990s, German industrial giant Metallgesellschaft’s US oil trading arm created a forward hedging market for energy product consumers out 10 years, buying nearby WTI futures in a beta hedging strategy which assumed a profitable contango and crack spread. Initially, MG were able to benefit from the backwardation roll on their nearby WTI hedge, until the scheme’s success saw the position increase above 50% of nearby WTI holdings. Once the rest of the market saw the rolls coming, they would pre-roll ahead of MG, forcing MG to roll up a steep contango. Add-in margin calls for MG against un-margined customer sales in a higher interest rate environment, and the scheme was liquidated early at a significant cost.
OPTIONS PRICING WAS CONSISTENT WITH A FLOOR PRICE OF MINUS $100/BBL.
Source: Reuters / ADMISI
25 | ADMISI - The Ghost In The Machine | Q2 Edition
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