Crude oil market commentary April 2020 – WTI and Black Swans
Here at TwoTwoFive we teach people about commodity trading. A lot of our teaching involves fundamental and technical analysis of markets, and specific concepts such as arbitrage and storage in a contango market (more on that later!). But we also cover some more subtle aspects of trading; the psychology and mindset of being a successful trader for example.
One psychological issue is confirmation basis; the natural tendency in humans to seek and favour information that confirms their views, and discount information that contradicts those same views. Most traders do this; if they are long, they focus on the bullish news and ignore anything bearish. We call this becoming “married to your position”, and just like in real life, if you stay married too long to a position that is not working out the inevitable separation when it comes can be unpleasant and costly! The best traders avoid emotional attachment to their trades; they view the market dispassionately and are quick to change their position when their market view changes. We won’t speculate on what their relationships are like, mind you!
A second issue around trading mindset is the ability to factor in the possibility of Black Swan events. Often traders spend a long time looking at price charts, identifying previous highs and lows, and looking for patterns. But it is essential to remember that past performance is not an indicator of future performance. Markets sometimes do something completely out of the blue, something no-one could have reasonably predicted. When this happens, traders need to be able to forget historical precedence and consider all possible outcomes.
As Dennis Gartman often says when talking about markets; “You have no idea how far down is once down gets started, nor have you any idea how far up is once up gets started”. However not many people are able to recognise that any market can do something completely unexpected and that when it does, it can reach levels (high or low) that you had never before imagined possible. When WTI/Brent differential started to behave unusually in 2010 who foresaw that it would discount to more than minus $25/bbl? When crude oil prices broke the $50/bbl level in 2005 who would have predicted they would rise to nearly $150/bbl? Of course, with hindsight these two examples don’t seem that extreme, we have adjusted to the “new normal” in these markets. But at the time these events were massive news and led to some huge losses as traders banked on markets quickly returning to historical norms.
A few weeks ago we had a Black Swan event in prompt WTI futures; On Monday 20th April May WTI collapsed from an opening price of around $18/bbl to a low of -$40/bbl (yes that’s minus 40) before closing at -$37/bbl. The following day (expiry day for May futures) opened at -$14/bbl and closed at +$10$/bbl. Yes, this was primarily a function of expiry of the futures contract, though in exceptional market circumstances. But it was also very much a Black Swan event. Nothing like this has ever happened before in an Oil futures market; a daily trading range of $58/bbl and a low of -$40/bbl?!
Funnily enough early in our courses we often use the example of NBP (UK delivery Natural Gas) which traded negative in October 2006 due to a perfect storm of increased supply (Langeled pipeline coming on stream), decreased demand (unseasonably warm weather) and virtually no storage capacity (96% utilised, effectively full). We use this example to emphasise the same point Dennis Gartman makes; you don’t know how far down is until down gets going, and by the way don’t assume down stops at zero. But despite teaching this principle countless times on various courses, could we have anticipated or been prepared for what happened to WTI last week? Probably not, it’s one thing to teach theory but another thing entirely to experience it in a market you thought you knew well and understood. But then the point of bringing psychology and mind-set into our courses
is to prepare delegates for the unexpected. You can’t predict future Black Swans by definition, but you can be prepared to radically change your thinking when they happen – and divorce yourself from your position quickly if you are wrong!
While we are on the gap between theory and reality, as mentioned above we often cover Contango markets in our courses. A Contango market occurs when prompt values are lower than prices for forward or future delivery. This is represented by the blue curve below. The opposite of Contango is Backwardation, the green curve below, when prompt prices are higher than those for future delivery.
If the difference between the prompt price and future prices is greater than the cost of storing oil for this period of time, then a supplier would be better off storing their oil and forward selling it at the future price, rather than selling it now. Rather than achieve todays price, they would get the future price which is greater than the current price plus the cost of storage. Some hedging may be necessary to secure this higher price but let’s not worry about that for now.
Of course, a key variable in the above analysis is the cost of storage. If markets are in Contango for a long time, storage will start to fill up and storage costs will rise. If all storage is full, then suppliers and traders will look at alternative storage – notably ships. If you can deliver into a vessel from your supply location, then you simply replace the storage costs above with the freight and delivery costs and store your oil on a ship.
At the moment, Oil markets are comprehensively in Contango, arguably to an unprecedented level. Storage is effectively full and floating storage (ships) are widely in use. On our courses we talk about previous times when storage has filled up and ports such as Singapore and Rotterdam have been full of vessels at anchor acting as floating storage depots. We make the point we have never seen a market where all storage is full and all vessels fully utilised; maybe we are guilty of not considering this Black Swan event? Well we are guilty because this is effectively what happened to WTI last week. Yes it was only for a short period of time, leading up to expiry, and exacerbated by the inland delivery point at Cushing, but nevertheless this situation was predictable, even if highly unusual. In fact, looking back to the Natural Gas example above, we have the same perfect storm in Oil at the moment; increased supply (OPEC+ price war impact), decreased demand (Covid-19) and virtually no storage capacity (tanks full and vessels heavily utilised).
So, what do we take from the above? Everything we talk about on our courses, whether it is market theory or trader mindset, is hugely relevant as today’s markets prove. And when Black Swan events happen the better you understand both the concepts and theories, and also the psychology of trading, the better prepared you will be. Oh, and you don’t know how far up or down is until they stop.
If you want to learn more consider trying one of our many E-Learning modules, maybe “Introduction to Storage” or “Advanced Storage”.
Meanwhile stay safe and thanks for reading this!