Morning Brief – Chill Pill

Chill Pill

Yesterday evening, following the close of the European trading session, I watched the price of oil in the United States completely collapse. The sell-off had been gathering momentum through the day. The most common instrument to measure the price of oil in the United States had opened yesterday’s trading day at $18 a barrel. At around 5pm London time, this instrument had reached $10 per barrel and, just after 7pm London time, it was quite literally worthless. There was a light volume in oil trade at these levels, however the price was recorded on the exchange in excess of -$40 per barrel. This is the first time oil prices had gone so low and turned negative in history despite wars and turmoil in major oil exporting regions. This morning there has been a lot of, how shall we put it, less-than-useful analysis so, let’s look at why the move took place, what it really means, and ask, does it matter for the foreign exchange market?

If you purchased a barrel of oil in the United States last night you would not only have received your barrel of oil but you would also have been paid a rather handsome sum of cash to take it. That’s a disturbing yet incredible state of affairs – if this was common place global trade would grind to a halt and the supply of energy across the globe be almost entirely unpredictable and therefore unpalatable. However, the dramatic shift was largely due to idiosyncrasies in the oil/futures market within which the commodity is traded and the specific nature of the instrument itself.

The ‘price’ in a market is nothing more than the last price or ratio at which a certain asset was exchanged with another one. In foreign exchange markets it is the ratio at which one currency last traded at against another; in equities it is the ratio of 1 unit of stock versus the applicable fiat currency; in commodities, including oil, it is the ratio of 1 unit of good in relation to the currency that facilitates its exchange. In Europe we hear about Brent Crude whenever the price of oil is mentioned. This is the global benchmark but strictly speaking it only demonstrates the price paid for oil from or traded within the North Sea. It is largely convention that keeps Brent Crude as the international benchmark but a sophisticated market has built up around it justifying its existence. The price of oil half way across the world is of little relevance to a buyer or seller of oil in the United States. They therefore have their own prices and own trading venues because geographic dislocation, differences in quality and domestic economic circumstances may all change what buyers are willing to pay and sellers are willing to receive for largely the same commodity.

The United States’ “West Texas Intermediate” (WTI) oil benchmark has one important characteristic. It is oil that largely comes from the Permian Basin but represents oil traded and settled in Cushing, Oklahoma – right slap bang in the middle of the United States. Sure, the oil can travel via pipeline to the Gulf of Mexico where it might be refined or perhaps to the Midwest but it is by its definition a land-based instrument, unlike the floating Brent Crude benchmark. It therefore involves storage and transportation costs that are unbelievably high at the moment due to a flood of demand to hold dirt-cheap oil until the price stabilises and it can be sold for reasonable profit.

The nature of this specific oil instrument in comparison with one other fact explains how the ‘price of oil’ turned negative last night. Oil is traded on futures contracts meaning there is one date each month, referred to as the expiry date, which dictates when trade must stop and completion of the deliverable contract must begin to take place. WTI had its ‘front-month’, the soonest traded and most highly referred to contract, expire yesterday. Therefore any oil traded had to be taken for immediately delivery offering speculators and those hedging their exposure no value and immense risk by taking on the contract as buying it now represented a commitment to take delivery of any oil purchased within a number of days. With no room at the inn to store the oil and no appetite to consume the oil’s by-products, the price collapsed and sellers were therefore willing pay buyers to take the bulky commodity off of their hands whilst the still could.

There are two important conclusions that we can draw from this 1) the oil market is saturated in the near term and the world simply doesn’t need any more oil-derived fuel products than it already has over the next month. 2) the stress in global markets created by coronavirus is still present in the near term. And what does that all mean? Well, not much! It’s far from deserving of the bold yellow line on the front cover of the FT this morning or the Bloomberg headlines decrying a flash crash in the price of oil before recovery today. They’re talking about irrelevant or even two different instruments! I can easily claim a near-100% depreciation in the value of a US Dollar if one minute I measure it versus Japanese Yen and the next against the Euro! So what are the implications for the foreign exchange market?

As you have derived by now whilst amazing to watch the panic ensuing in markets last night it was limited to a very small but publicised arena of the oil market. It did continue to function and the move into negative prices was evidence of this as the ratio switched around to facilitate the exchange of Crude traded under specific constrains. The only real implication for foreign exchange markets will be what the Donald makes of this shake up. Due to the threat to the US Shale industry he was quick to react to the fall out between Russia and the Kingdom of Saudi Arabia. Increases in volatility and even normalisation caused by the President increasing this pressure will have real importance. For now though, the price of the global commodity when considered reasonably is almost entirely unchanged from its crash last month and market conditions remain the same this morning.

Discussion and Analysis by Charles Porter

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