HedgeTalk: WTI Futures Drop Below $0.00 for the First Time

By: John Trefethen, Director & Co-Founder

Another decline occurred with oil prices earlier this week that had a ripple effect in equities and currencies, also driving them lower. Chicago-based CME is home to the West Texas Intermediate (WTI) futures contract, which is a popular hedging instrument for oil producers and consumers wanting to hedge volatility in oil prices. It is also a popular investment vehicle for speculators on the direction of energy markets. Futures are contracts that help hedgers manage price risk, and speculators bet on the future price of commodities. Unlike stocks, futures can sometimes drop below zero, particularly in physical markets where storage facilities can reach capacity. Negative prices have occurred in futures on natural gas and electricity – but until this week they have not occurred with the WTI contract. That changed on Monday this week when the WTI futures for May delivery fell to -$37.63 before rebounding to a still near historical low of $10.01 on Tuesday, when the May contract expired. What drove the WTI contract temporarily negative, and to a price at expiry that remains below the cost of production, is that supply is currently outpacing demand by two to three times. This is the market signaling to producers that they need to cut back on production. The impact of low oil prices is especially evident in the current weakness of the currencies of countries with economies heavily concentrated in oil production, in particular Russia and Mexico. WTI is usually extracted from US oil fields in Texas, Louisiana and North Dakota. WTI futures are tied to the price of oil delivered each month from these areas to the storage hub in Cushing, Oklahoma. Brent crude is extracted from the North Sea and Brent futures track the price of this seaborne crude, relying on an index calculated by the Atlanta-based Intercontinental Exchange, commonly referred to as ICE. Brent crude is the international benchmark used by OPEC, while WTI the price is the benchmark for US oil prices. Typically, low oil prices in the US would encourage traders to buy cheap US oil and sell it at a profit in Europe and Asia. However, the Brent futures contract also declined earlier this week, albeit not into negative territory or as much as WTI. WTI fell 306% on Monday while Brent fell 24% the following day. This is indicative of there also being storage issues outside the US, though not currently as dire as in the US. The graph below shows the correlation that generally exists between WTI and Brent, and the significant divergence that occurred earlier this week.

In normal times low oil prices are difficult on producers but deliver a silver lining in the form of attractive prices for consumers. These are not normal times and there is no silver lining for consumers with little need for oil. The WTI futures contract prices as of April 22, 2020 range from 14.23 for the Jun 2020 contract to 31.44 for the Mar 2021 contract. Historically speaking, these are attractive prices for consumers as they are well below the cost of oil production in the US. But the many unknowns related to COVID 19, in particular not knowing how long the economy will be shuttered and oil demand will remain low, make it challenging to know if this is the right time for oil consumers to hedge future oil prices to preserve margins in the second half of 2020. Limitations in the structure of futures contracts make it more challenging to hedge price risk with this level of uncertainty. This may be a time for hedgers to consider executing hedging derivatives beyond just WTI and Brent futures. OTC derivatives (i.e. swaps) have more structure flexibility relative to futures contracts, and can be structured in a way to better manage the current level of market uncertainty - and offer protection from futures contracts that have the potential to go negative…again.