This week has delivered a historical moment for the trading markets – for the first time ever, oil prices turned negative, due to the coronavirus pandemic significantly reducing demand for the commodity. Now that the reality of the situation has set in, market participants are already closely eyeing other energy commodities – which will be the next to fall?
As Finance Magnates previously analysed, lockdown measures in response to COVID-19 have stopped billions of people from travelling which has significantly reduced the demand for oil, creating an oversupply for the commodity, which saw the price for WTI futures (West Texas Intermediate) for May fall drastically.
Should we be preparing?
However, this same situation can be applied to other energy commodities, which covers a variety of coal, oil, and gasoline derived products. So, should we be preparing for other commodity prices to turn negative?
According to Stephen Innes, Chief Global Market Strategist at AxiCorp, the WTI concerns, which was the futures contract that went into negative prices, was widely attributed to localised physical settlement and restricted storage issues at Cushing, Oklahoma.
“But the problems at Cushing have set a new theme for the markets as traders are just as distressed about front contract settlement risk as they are about the relative value of oil. This is creating an incredibly messy proposition for oil price discovery and the pegging a relative value for oil prices via cross-asset correlations,” Innes told Finance Magnates.
“And, of course, this could happen all over again. Still, prudent risk management policies will take precedence over risk-taking adventures into the June expiry date. Ongoing de-risking adjustments in the front date contract are being made as I speak. And for the near term, the market may shift further out the curve to less volatile risk proxies.”
Brent oil, gasoline and heating oil at risk
When asked if he believed any other energy commodities were in danger of following in the footsteps of oil, Charalambos Pissouros, the Senior Market Analyst at JFD Group said: “In my opinion, yes.”
“Bearing in mind that the restrictive measures due to the fast-spreading coronavirus are still intact, people are likely to stay home for a while more before they start to travel again. Even if governments around the globe start loosening the restrictions, this is likely to be a very slow procedure, and thus, we see the case for crude oil demand to return to its pre-virus levels as unlikely.
“Thus, with storage tanks getting full, we cannot rule out another round of selling, despite yesterday’s rebound. Yes, there are hopes that Saudi Arabia and its OPEC+ allies will proceed with extending or expanding the already agreed production cuts, but the big question is: Will this be enough to offset the diminishing demand? If not, I cannot rule out another round of negative WTI prices.
“Other energy commodities that are exposed to such risk is of course Brent oil, which is almost perfectly correlated with WTI. Other commodities of which the correlation with WTI is very high are gasoline and heating oil, as by definition they are made from crude oil. One of the commodities which is not correlated with WTI is natural gas, which is an alternative form of energy, and it may be unlikely to follow the footsteps of oil derivatives.”
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When could we see further negative prices?
If further energy commodities are at risk of going into the negative territory, how long do we have? According to Pissouros, it might not take long. “As long as the “stay at home” measures are still in place, and the storage space for oil is getting less and less, we cannot rule out another dive,” he explained.
“The reasoning behind Monday’s tumble is that holders of May WTI contracts were willing to pay people in order to get rid of them, instead of taking delivery and the burden of paying extra storage costs. So, why exclude the possibility of a similar reaction when the June contracts get close to their expiration date? And why exclude the likelihood of other oil-related commodities to follow suit?”
Are traders and brokers ready?
When prices went negative in the US oil market, the industry was not ready, as prices have never gone negative before. Because of this, the losses are likely to be big. Interactive Brokers posted an aggregate provisionary loss of approximately $88 million.
However, as Finance Magnates reported, the US brokerage firm had around 15 per cent of the open interest in the May oil contract, according to its founder, which indicates that other brokers have suffered even more dramatic losses than Interactive Brokers, as the rest of the open interest faces losses. GAIN Capital also temporarily paused withdrawals for some of its clients, the company confirmed to Finance Magnates, as the unprecedented price action on Oil on Monday has led to the broker reviewing some positions held by clients.
“Given the relatively muted action on FX currencies and oil majors (stocks) suggest that traders are taking a level headed approach to oil market correlations. And are starting using an average weighting of the current 12-month oil futures contract to base guidance,” Innes commented.
“FX and Oil majors (stocks) decouple from the underlying front month and while shifting towards expectations of a positive price correction in Q3. When it comes to June WTI, it feels like the markets are flogging a dead horse due to settlement risks, which suggests June could become a dead contract as open interest, paper, and real, logically shifts July and beyond to get exposure to oil.”
Brokers react and prepare
Although the market was caught off guard, a number of brokers tried to reduce the damage by closing their client’s positions for the affected products, suspending trading, and a range of other measures.
When asked how AxiCorp was preparing for similar moves in the future, Louis Cooper – Chief Commercial Officer at the broker outlined: “At Axitrader, our primary concern is the safety of our clients. These are unprecedented times in the financial markets, and particularly in Oil as demand for the commodity has tanked, lack of liquidity has caused erratic market movements and the price of Oil is at historic lows.
“Given our concerns regarding the liquidity in the underlying Oil Futures contracts, we’ve already asked clients to increase their trading margin to manage large price movements which may impact their current positions.
“We’ve also decided to only allow clients to reduce or close positions as we’ve seen a high demand for speculative trading on Oil, which we believe at this time is a high-risk strategy and should be avoided. It’s important that traders evaluate the risk vs. return when trading markets in such uncertain times, and to protect themselves from significant losses.”