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So I’ve been seeing a lot of speculation and confusion about why oil futures have remained so low despite the historic supply disruption, and why the spread between futures and physical prices is so big. I have a bit of a background in oil, so I’ll try to explain it based on my understanding. Just to be clear, this is something that’s baffled a lot of commodity experts, so I’m not claiming this is the 100% accurate assessment, it’s just my personal thesis at the end of the day.
Before we jump into the conflict and the situation with Hormuz, we need to first understand what was going on with oil markets leading up to the war:
1. The Cash and Carry Trade
Before the onset of the war, a lot of traders were engaged in what is called the “cash and carry trade.” In a healthy, stable oil market, the futures price curve is in “contango.” This means that future prices are higher than spot prices. Why? Given stable supply and ample storage, the future price of a barrel of oil is typically higher than it is in the present due to cost of storing oil (storage, interest, insurance).
How it works: In a cash and carry trade, traders take advantage of this contango situation by buying cheap physical oil in the spot market and simultaneously short selling a futures contract for delivery several months out. They store the oil, sell the futures contract then profit the difference. In normal situations this is a stable, low risk profit.
This is the “carry.” Sounds too good to be true right? Well 99% of the time it’s actually pretty safe. But sometimes you end up with our current disastrous situation, and you might just be fucked.
2. Supply Disruption and Backwardation
In extreme circumstances when there is a great supply or demand shock, the futures curve reverses and we enter a situation called “backwardation.” In backwardation the cost of spot oil is GREATER than the cost of futures, because buyers want oil NOW NOW NOW. This spikes the price of immediate physical oil, making it higher the cost of futures because the market expects the shock to subside with time and for future demand to settle.
We are currently in this situation. The closure of the Strait of Hormuz is easily the largest physical supply disruption we’ve ever seen, period. Nothing else compares. There is a massive shortage of oil and buyers are desperate for any barrel they can get. They want it now.
This backwardation scenario is a nightmare for cash and carry traders. Why? Because if you were already running this trade before the war started, assuming continued contango, you are now trapped in this backwardation. When the war hit, the front month contract (which they were short), exploded in price. These traders are now facing huge, open ended losses. Every dollar that oil rises in the front-month, the bigger their loss.
Under this circumstance, the ideal scenario for these traders would of course be for the war to resolve and for prices to return to normal. As the war drags on and the supply disruption deepens, however, this obviously seems more and more unlikely. Failing this then, the next best thing would be to have the futures curve suppressed for as long as possible, long enough for them to reposition and find ways to exit their trade while minimising losses.
3. March futures and the Hope Trade
As I’m sure you’ve all noticed, the futures prices remained relatively low despite soaring spot prices.
In March, there was still significant hope for a ceasefire and a resumption to the flow of oil. There were also several supply buffers still in place to cushion the blow. Most significant were: the presence of “free” WTI (available oil) in Cushing, Okalahoma that could still be used to settle futures contracts, global SPDR releases and the presence of floating storage (tankers at sea that hold oil, waiting to be sold.)
The Russian and Iranian oil sanction releases in my opinion made little to no difference; that oil was being sold anyway.
Given all these factors, when futures contracts expired in March, the system could still absorb oil deliveries as there was enough oil in circulation for arbitrageurs to execute their trades in light of severe backwardation. This allowed, despite the volatility of oil futures, a more gentle convergence as contracts expired. The big dreaded spike to 150+ did not come.
Additionally, due to the cash and carry trade, there was a massive vested interest in having futures prices under control long enough for a tangible resolution to materialise and for oil flow to resume, thus bringing the price of oil down. And this interest does not stop with these institutional traders; governments and banks around the world are all aligned in their hope of keeping oil futures under control in time for a resolution.
The futures curve is therefore priced based on this intrinsic hope that things will resolve quickly; there has to be a resolution lest the people in these positions suffer massive, unmitigated losses. It is also why oil markets were so eager to react positively to Trump’s rhetoric. They were literally primed to do so.
4. April: The end of hope and the convergence
You’re probably thinking then, can they keep doing this? Could they in theory just prolong this hopium indefinitely until we get a resolution?
Well, my answer is….no.
“Yesterday’s oil,” that is the oil available for arbitrage in Cushing and floating storage waiting to be sold around the world, are gone. You might see if you look this up that Cushing actually still has around 21 million barrels in storage. This oil however is already committed. This is what is known as the “tank bottom,” the operational minimum committed to refineries to maintain operation. These cannot be used by traders.
What about the SPDR? These reserves are allocated to specific refiners to alleviate the price spike. It will not be available to traders either.
JP Morgan put out a pretty good write up on this detailing the specific math of it all. But to put it shortly, there’s no more oil left to deliver against oil futures. When these buyers fail to secure supply to fulfill their contract, they will then be forced to buy back their contracts to fulfill their position. This rush of buying will trigger a short squeeze. This is when the paper oil prices spike violently into the stratosphere.
Can’t they just roll their contract then? Well with the available oil buffer gone, there won’t be liquidity on the paper markets. They either have to hold it to expiration or deliver. But there’s nothing to deliver.
April 21 is when many of these contracts expire, and these buyers will then be forced to find physical oil for delivery. This is when things will be really interesting. I will say though, so far the spread between paper and spot has been so absurd, I would not be surprised if there were more shenanigans that kept paper prices low. I do not however, see a practical reality where they simply diverge indefinitely. By the end of April or at the latest mid-May\\\*, something has to go.
*I tried posting this on the oil subreddit but apparently they don’t want more low quality oil price posts so here I am.*