We recently explained “How the Oil Price Could Fall Below Zero.”
The piece felt a little “out there” because, at the time it was written, the possibility we were explaining — oil contracts trading below zero — had never happened before.
When we explained how the oil price could go negative, we thought a looming lack of storage space might cause it to happen in a matter of months, or possibly a matter of weeks.
Instead it happened the very next trading day.
The TradeSmith Daily broadcast went out on April 17, a Friday — and the front-month crude oil contract closed at negative $37.63 on April 20, the following Monday. Talk about a fast turnaround!
The reason it happened so fast is kind of fascinating.
That is to say, all of the big-picture reasons we explained were certainly in play — a stunning collapse in global demand, tankers filling up, nowhere to put the oil — but crude went negative in a stunning hurry, on April 20, for a quirky, hidden reason.
It has to do with the nature of USO, the popular exchange-traded vehicle, and a professional arbitrage trade gone epically, spectacularly wrong.
To give you a sneak preview of the conclusion, a number of professional energy traders likely went bankrupt on April 20, as a supposedly risk-free arbitrage spread blew up in their face.
To explain what happened, we’ll start by noting that the United States Oil Fund, ticker symbol USO, is technically an ETP rather than an ETF.
An ETP is an exchange-traded “product,” which is different from an exchange-traded “fund.” The difference comes down to the way the vehicle is structured. ETFs are typically composed of plain vanilla equity holdings. ETPs can invest in strange or exotic instruments — like futures contracts.
USO is (or rather was) a popular way for retail investors to wager on the price of crude oil. USO would facilitate this by investing in front-month WTI crude oil futures. The process looked like this:
- Retail investors would buy USO because they were bullish on oil.
- As new money came in, USO would purchase crude futures contracts.
- USO was thus a proxy for being long front-month crude oil futures.
Sometimes retail money would flow aggressively into USO, and the net asset value, or NAV, would be higher than the actual value of the futures contracts being held.
Say, for example, USO had a net asset value of $3 billion, but it was sitting on $2.5 billion worth of futures contracts. In that instance, USO would be overvalued by $500 million — the difference between the net asset value (NAV) and the actual value of the crude oil contracts held by the fund.
This created an arbitrage opportunity for professional energy traders. They could “arbitrage” the inflated value of USO against the actual crude oil futures contracts.
When you arbitrage something, you find different versions of the same asset, trading at a different price in one place versus another. Then you sell (or sell short) the expensive version, buy the cheaper version to offset price risk, and lock in the difference.
So, when USO would trade above the value of its underlying crude contracts, professional traders could:
- Go short USO, which is like shorting $X worth of futures at an inflated value.
- Go long the equivalent amount of actual, lower-cost crude futures contracts.
- Pocket the difference to lock in profits over time.
To put it another way, investors who were buying USO at an inflated net asset value (NAV) were making a mistake. They were paying a premium (though they didn’t know it or didn’t care) to gain exposure to the underlying crude oil contracts.
Professional traders were thus creating a transfer of retail investor capital into their own pockets by shorting USO, then buying a block of lower-cost actual crude futures contracts against it.
This arbitrage trade tended to persist over time because a lot of retail investors wanted bullish exposure to oil, but they didn’t want to mess with futures and they weren’t sensitive to hidden premiums. So, they bought USO and happily inflated the NAV.
So far, so good. The professionals had found a way to make money off mom and pop — as they love to do that when they can — with a supposedly risk-free trade.
But on April 20, it all went wrong for the pros.
The contract that closed at negative $37.63 on April 20 was the May crude oil futures contract. It was due to expire the very next day, on April 21.
Under normal circumstances, the trade works fine. You are short USO, and long front-month contracts, and you sell your longs on the last day (or just prior) before the futures contract expires.
Except, if the price of oil falls below zero — which had never happened before! — you are suddenly a dead duck, because your arbitrage play stops working.
The point of buying crude oil futures was to hedge the risk of being short USO. But on April 20 the hedge portion went bad — very bad — as crude oil futures went negative while USO did not.
Picture these energy traders who are used to scooping up nickels with this easy arbitrage play.
To make it profitable they would run the trade in huge size, using a lot of leverage, because the amount of premium they are capturing (via shorting USO at inflated NAV) is very small.
So far, so good — except they are long a boatload of futures contracts. Their size is huge because they thought the play was “risk-free” — they were locking in one commodity price against another.
But then the front-month futures contract trades below zero, and of course USO doesn’t follow it below zero because that doesn’t work for exchange-traded vehicles.
An exchange-traded product can’t go negative, but the futures can, and do — and suddenly the pros are in panic mode.
They have to get out of their long May futures contracts, which were the “hedge” side of an arbitrage trade now gone bad, and they have to get out at literally any price, no matter how low.
Meanwhile there are no commercial buyers of crude at any price at all — again, no matter how low — because of what’s happening in crude oil markets.
And that, ladies and gentlemen, is how you get an oil futures contract trading at negative $37.63 per barrel for the first time in history.
A bunch of smart energy arbitrage guys who were long futures contracts (and short USO against those contracts) suddenly looked not smart at all, and they were ultimately forced to sell at any possible price — even a price straight out of a Monty Python skit (minus $37).