- A wild ride in crude oil.
- Contango caused storage capacity to fill to the brim and the price to go negative.
- Production cuts around the world.
- A natural decline in output in the US.
- UCO and SCO for those that do not trade futures.
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A perfect bearish storm hit the crude oil market in early March 2020. The spread of COVID-19 outside China’s borders caused demand for energy to grind to a halt as businesses closed, and social distancing guidelines locked individuals worldwide in their homes. The self-induced coma in the global economy made the demand for energy evaporate in what seemed like a blink of an eye.
At the same time, and in their infinite wisdom, the international oil cartel and Russia decided to flood the world with petroleum when demand was plunging. The price of crude oil became a falling knife that led it to the lowest price in modern history in late April on the nearby NYMEX crude oil futures contract.
As crude oil fell on the back of soaring supplies and almost no demand, the spreads between crude oil for nearby and deferred delivery widened. Traders worldwide with access to capital began buying nearby crude oil, storing it around the world, and selling for the future at widening spreads. The trade was profitable as long as the cost of finance, storage, and insurance was below the contango or forward premium. Some traders without access to storage and physical delivery began synthesizing the trade by buying nearby NYMEX futures and selling deferred contracts expecting the spread to narrow. Some of those holding May contracts on April 20 received a shocking surprise when the price fell far below zero. Crude oil became a bearish hot potato.
Meanwhile, contango has declined steadily throughout May, yielding significant profits for a handful of oil traders. Time spreads along the forward curve can be as volatile as the price action in the nearby contract that tends to attract the most speculative volume. As the world’s producers strive for a fundamental balance in the energy commodity, volatility is likely to continue. The United States Crude Oil Fund (USO) is the leading unleveraged ETF product that follows the price of WTI NYMEX crude oil higher and lower. For trading purposes, I prefer, the ProShares Ultra Bloomberg Crude Oil product (NYSEARCA:UCO) and its bearish counterpart (SCO) as they magnify the price action. The action in the forward curve makes USO a challenge for medium to longer-term risk positions because of the volatility of the forward curve in the crude oil future arena. The forward curve’s price action continues to point to more price variance in the energy commodity at the end of May.
A wild ride in crude oil
This year has been more than turbulent when it comes to the crude oil market. In 2020, the price range of the continuous futures contract on NYMEX has been $105.97 per barrel.
As the weekly chart of the nearby futures contract shows, the high of $65.65 came at the start of the year as hostilities between the US and Iran on Iraq caused supply concerns. The low was on April 20, when the expiring May contract fell into negative territory as West Texas Intermediate light sweet crude oil became a bearish hot potato. With nowhere to store the landlocked crude oil with its delivery point in Cushing, Oklahoma, holders of futures contracts had no choice but to sell at any prices, which drove the price to the lowest level in modern history.
On May 29, the price of July futures was above $33 per barrel, just below the recent high at $34.81. The recovery caused price momentum to rise to an overbought condition, while relative strength was at a neutral reading on the weekly chart. Weekly historical volatility had climbed to a high of over 172% in mid-May but declined to the 130% level on the final trading session in May.
The total number of open long and short positions in the NYMEX futures market fell from 2.39 million contracts in April to 2.13 million as of May 28. After falling into negative territory on April 20, the energy commodity had posted gains over the past four consecutive weeks. It moved mostly sideways during the final week of May.
Contango caused storage capacity to fill to the brim and the price to go negative
As the price of crude oil fell from the January high of $65.65 per barrel, the backwardation in crude oil disappeared and turned to contango. The flood of crude oil caused nearby prices to decline compared to prices for deferred delivery.
As the chart of the July 2021 minus July 2020 spread in NYMEX futures shows, it moved from a backwardation of $5.65 per barrel in early January to contango of $13.46 in late April, a swing of $19.11 per barrel. Oil traders around the world bought nearby crude oil, put it in storage, and sold deferred contracts to take advantage of the spread. Since the cost of financing, storing and insuring the petroleum was under the level of contango, the position yielded a locked-in profit. Some traders synthesized the position by purchasing nearby contracts and selling deferred contracts. As storage capacity disappeared, those without the ability to house the oil found themselves in a position where they had to sell at any price or roll long positions to the next active month as the nearby contract expired. The widening contango pushed oil below the price of zero on the May NYMEX contract.
Since late April, contango has steadily declined. The July 2020 versus July 2021 spread was at the $3.87 per barrel level on May 26, almost $9.60 below the level at the end of April as the fundamental equation moved towards a more balanced position.
Production cuts around the world
In April, before the price of May NYMEX futures took a trip into negative territory for the first time, OPEC, Russia, and other oil-producing nations in the world announced an unprecedented deal to address the evaporation in demand with a 9.7 million barrel per day cut in output. However, the move was not enough to compensate for the loss of demand, and the price fell to the lowest level in modern history for WTI and $16 per barrel on Brent futures. Brent fell to its lowest price of this century. The almost ten-million-barrel reduction in production was for an initial two-month period.
After oil collapsed, Saudi Arabia announced it would cut another one million barrels per day as of June 1, and other OPEC members from the Middle East also cut output.
A natural decline in output in the US
Meanwhile, US production fell from a record high of 13.1mbpd in mid-March to 11.4 mbpd as of May 22, according to the EIA. Baker Hughes reported that the number of oil rigs operating in the US was at 237 as of May 22, 560 below the level operating in late May 2019. In the world of commodities, the cure for low prices is low prices. Crude oil fell to levels where the market price was below production cost, causing a natural decline in US output.
The price of crude oil has been steadily rising since late April in a sign that falling supply is moving towards a level that balances the fundamental equation. At the same time, the demand for crude oil from China has been rising over the past weeks, and parts of the US economy are slowly starting to reopen. We are now at the start of the summer driving season in the US, which is the peak time for gasoline demand. Falling supply and rising demand have stabilized the price of the energy commodity over the past week. However, any further outbreaks of Coronavirus that cause businesses to close down again and force people back into their homes could put a sudden end to the recovery in the oil market.
Since the Middle East remains a highly turbulent political area, any hostilities that involved the Iranians that threaten production, refining, or logistical routes could cause sudden price spikes if supply concerns return to the oil market. However, the massive inventories in storage around the globe would likely cap any rallies.
UCO and SCO for those that do not trade futures
The price of crude oil has already traded in an over $100 per barrel range on the nearby NYMEX futures contract in 2020. In Brent, the band has been around $56 per barrel. Since Brent is a seaborne crude and WTI is landlocked, storage capacity created the huge trading range in WTI when the futures spiked below zero.
I do not expect the price of crude oil to trade outside of its trading range on WTI or Brent futures for the rest of 2020. However, we could continue to see wide price swings in the energy commodity.
The path of the forward curve continues to support the recovery in the price of the energy commodity. The July-July NYMEX spread had declined to the $3.87 per barrel level on May 29. The same Brent spread was at around a $5.70 per barrel contango, which is significantly lower than in late April.
Volatility in crude oil creates trading opportunities. The most direct route for a risk position in the energy commodity is via the futures and futures options that trade on the NYMEX division of the CME. Those looking for a leveraged product to trade crude oil on a short-term basis could use the double leveraged ProShares Ultra Bloomberg Crude Oil product (UCO) and its bearish counterpart (SCO).
The fund summary and top holdings of UCO include:
Source: Yahoo Finance
UCO has net assets of $857.66 million, trades an average of around 19.8 million shares each day, and charges a 0.95% expense ratio. The price of July WTI futures rallied from $17.27 in late April to a high of $34.81 per barrel on May 26, a rise of 101.6%.
Over the same period, UCO rose from $11 to $24.10 per share or 119%. The decline into negative territory caused USO to alter its hedging structure, so the product did not deliver when it comes to a 200% exposure to the price of nearby NYMEX futures.
The USO unleveraged product moved from $16.88 to $27.49 per share over the same period or 62.9% over the period, almost half the percentage rise of the UCO product.
The bearish SCO product has net assets of $173.69 million, trades an average of over 5.66 million shares each day, and charges the same 0.95% expense ratio as UCO. The top holdings of SCO include:
Source: Yahoo Finance
From April 9 through April 28, the price of July NYMEX futures fell from $35.17 to $17.27 or 50.9%.
Over the same period, SCO rose from $18.77 to $65.87 per share or over three and one-half fold. Changes to the hedging structure of the SCO product could cause under a 200% return compared to the price action of the nearby NYMEX futures contract in the coming weeks and months.
Both the UCO and SCO products track the price of NYMEX crude oil futures and are efficient substitutes for crude oil futures contracts. However, the tools only trade during hours when the US stock market is open, and crude oil futures trade around the clock from Sunday evening in the US through Friday afternoon. UCO and SCO do not capture any price spikes during hours when the stock market is closed.
Contango in crude oil has been falling steadily. As long as that trend remains intact, it supports a higher price for the energy commodity. I expect lots of two-way price action in both the spreads and the outright price of crude oil over the coming weeks. Trading, rather than investing in the crude oil market, should continue to be the optimal approach to the volatile market.
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This article was written by
Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup.Over the past two decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities.
Andy understands the market in a way many traders can’t imagine. He’s booked vessels, armored cars, and trains to transport and store a broad range of commodities. And he’s worked directly with The United Nations and the legendary trading group Phibro.
Today, Andy remains in close contact with sources around the world and his network of traders.
“I have a vast Rolodex of information in my head… so many bull and bear markets. When something happens, I don’t have to think. I just react. History does tend to repeat itself over and over.”
His friends and mentors include highly regarded energy and precious metals traders, supply line specialists and international shipping companies that give him vast insight into the market.
Andy’s writing and analysis are on many market-based websites including CQG. Andy lectures at colleges and Universities. He also contributes to Traders Magazine. He consults for companies involved in producing and consuming commodities. Andy’s first book How to Make Money with Commodities, published by McGraw-Hill was released in 2013 and has received excellent reviews. Andy held a Series 3 and Series 30 license from the National Futures Association and a collaborator and strategist with hedge funds. Andy is the commodity expert for the website about.com and blogs on his own site dynamiccommodities.com. He is a frequent contributor on Stock News- https://stocknews.com/authors/?author=andrew-hecht
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