The financialization of oil markets meets non-commercial v. commercial meets COVID-19. A thread….

The oil futures market is a zero-sum game. For every buyer of a futures contract there needs to be a seller. The purpose of the exchange was/is to provide a ‘regulator’ between the buyers and sellers so that folks know their counter party will perform.

Therefore, you have margin calls, the exchange needs to know that people will perform. Participants are put into two categories: commercial & non-commercial.

Commercial participants are those that use the exchange to hedge their physical product exposure and non-commercials use the exchange to buy low & sell high. Margin requirements are higher for non-commercials since they have nothing to offset (physical business) their futures.

What began in 2003, the financialization of the commodity markets led to historic capitulation today in the oil market. Investors believed that oil was a proper hedge to inflation, that along with the rise of hedge funds & money flows into commodities.

The increase in non commercial participants increased commodity market volatility. While I joke, back in the day the oil price didn’t move much intraday. It is a very small market when compared to other markets.

I find it interesting how the volatility in price dominated the oil market conversations in the mid-2000s. In this day in age, it is simply expected.

Many commercial players have risk parameters around their hedging practices. They need inventory for their business, and they need to hedge that physical commodity thanks to the volatility.

Corporate governance limits how large of a hedge position is held in the front month as expiration approaches. The amount of open interest declines the closer you get to expiration. Fewer market participants or volume to trade results in higher volatility.

Commercial players are already trying to mitigate risk so there is no need to hold a hedge in a volatile market. Non-commercial participants enjoy that volatility, they’re speculators and the more volatility the more opportunity there is to generate P&L.

COVID-19 created an unprecedented event in the oil markets. Its halted demand, virtually overnight. While the oil supply chain has a level of flexibility, production of wells and refinery operations don’t simply stop. It takes time to reduce production.

The demand reduction took place in such a rapid manner that the supply chain simply didn’t have time to respond.

These three themes lead to the capitulation of the WTI – May futures contract on April 20th, 2020.

Examples of natural buyers of an expiring futures contract. 1. Get long for a one-day speculative trade. 2. A squeeze by a commercial participant to take delivery. 3. A short position covering.

Some commercial participants that could buy a May futures contract and take delivery may not have the ability. This doesn’t’ mean that they don’t have storage space, it just means that their space is spoken for with future supply so they can’t take delivery of the May contract.

Its a timing issue. They may already have a delivery scheduled into their tanks around the same time that they would take delivery from the exchange.

In my opinion, this was a squeeze. The longs had to offer the price to a level that was attractive enough for someone to buy. With small volume and small open interest, it does not take much to move the market.

Open interest for May to begin the trading session was 108,593 contracts and total volume traded was 154,052 contracts. The June contract volume today was 1,165,842. It just so happened that the attractive price to bring in a buyer bottomed at -$40.32.

This smaller volume creates higher volatility which non-commercials view as an opportunity. With this opportunity comes great risk. Time will tell us about today’s winner and loser.

We will talk about today until we die, but remember, you're only as good as what you execute.