How ETFs broke the oil market

“Unprecedented” is a word that we hear a lot these days. Yet this week’s collapse in oil prices, which saw US crude fall by 321% from $18.27 on Friday to as low as -$40.32 on Monday, then rise by -106% to $2.54 by Tuesday (yes, those minus signs are mathematically in the correct places) before going negative again doesn’t just feel unprecedented – it’s almost inconceivable. 

There is a solid fundamental reason for rock-bottom oil prices: the destruction of demand resulting from the coronavirus crisis. But the bizarre idea that a economically vital physical asset such as oil can have a negative price is harder to justify . A chief villain and potential victim may even be one and the same: exchange-traded funds (ETFs) such as the $3bn US Oil Fund that track the price of oil.

Overflowing with oil

The oil price in question is a futures contract: West Texas Intermediate (WTI) grade oil, to be delivered to Cushing in Oklahoma in May. The supply glut means storage at Cushing is already fully leased for May. Since the May WTI contract stopped trading on 21 April, any buyers who didn’t have storage available had a major problem – and hence prices went negative because they were desperate and needed to pay other traders to take the oil off their hands.

Oil ETFs rely on futures. They buy contracts for the nearest month, but cannot take delivery of the oil, so must regularly sell these to roll their position over into the next month. If they get too large, this process could theoretically distort trading: first by hoovering up all the short-term futures that other traders are willing to supply, then dumping them on the market at rollover. US Oil Fund is hugely popular and may be big enough for theory to become reality: it held 25% of the May contracts, which may have created selling pressure when it began rolling these into June, helping push prices down. 

The fund had reportedly finished selling by the time the price went negative. It’s now spreading its positions out into July and August contracts to reduce its exposure to each month. But with storage full, the June contract (now at $11.57) could turn negative. If that happens while ETFs still hold it in large amounts, it’s unclear whether they could survive.

Even if oil ETFs avoid disaster, their returns in this crisis are likely to be dreadful and a reminder of their major flaw. If prices for the near month are lower than prices for the second month (known as a contango – see below), they suffer a loss every time they rollover. That’s why the long-term returns from oil ETFs are usually worse than returns from oil (the losses on each roll eat into any gains from rising prices) – and why they are only suited to short-term trades.

I wish I knew what contango was but I'm too embarrassed to ask

A futures contract is an agreement to buy or sell an asset – such as oil, gold, currency or shares – at a prearranged price on a prearranged date (known as the delivery date). 

Futures may be physically delivered (which means that the seller must deliver the asset to the buyer) or cash settled (which means they exchange a payment based on the difference between the initial price and the price when the contract expires). Futures contracts for any asset are usually available with a range of delivery dates – this may be monthly, quarterly or less regular (for example, some delivery dates for crops may be aligned with harvest months). 

Each futures contract trades independently, with the price reflecting expected supply and demand on a given delivery date. For example, demand for heating oil is higher in the winter than the summer, so futures with delivery in winter months should trade at a higher price than those for delivery in summer. But the relationship between different months is not constant. If there is a sudden shortage of supply, prices for immediate delivery (known as spot prices) and for the futures contract with the next delivery date (known as the near month or front month) might shoot up. Conversely, a short-term supply glut might cause spot and front-month prices to fall below prices for delivery in later months (known as back months or far months). 

A situation in which spot prices are lower than front month futures and the front month is lower than far months – ie, a curve of prices that slopes upwards – is known as contango. The opposite situation, in which spot prices are higher than front month prices and back months are lower still is known as backwardation. 

Futures curves will move between contango and backwardation depending on factors such as supply and demand, and the actions of speculators and hedgers trading the futures.