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If you do not know on Monday, 20-Apr-20, in the US, Crude Oil FUTURES fell below $0 a barrel to -$40. Yes MINUS $40. So basically the sellers of Crude Oil futures had to become buyers (closing the trades), to get delivery of Crude Oil. So the buyers were actually paying the sellers, to get their hands off the stock they have to keep in their stores, in the US.
What do ‘negative prices’ mean?
You see, oil is produced and kept in stores. This involves cost. Oil producers and sellers make a profit only when it is sold at a higher level than all costs, including such as producing, transporting, storing and labour. Unfortunately, there are no buyers in such a market when the US went on a complete lock-down. So even storing was getting difficult and costly.
If they were making a profit, even very small, the price would have not gone below ZERO, but even storing oil is a loss – so the price of futures went below zero. In other words – negative returns for future traders and HUGE LOSS for buyers (both futures and crude oil buyers).
Oil producers in the US were paying buyers to take the barrels of oil off their hands because storage facilities were full. They could not keep the oil anymore.
At the market’s lowest point on Monday, 20-Apr-20, an oil company might have paid about $40 for every barrel of oil someone was willing to take.
Understanding the Last Trading Day in the US
The last trading day is the day before a derivative expires. On the expiry date, the derivative is no longer trade-able (in cash) and the settlement process begins.
What is the Settlement Process
A future seller will have to take physical delivery of the stock/commodity equal to the lot size traded. If he sold a future for 100 and bought it at 60, then he gets the physical delivery of the stock/commodity at 60 which he will have to pay to the seller to close the contract. But he sold for 100, so once the prices rise he can always sell that at a higher price and not close the contract – he then profits if the settlement price is more than the buy price.
90% of the future contacts are speculative trades and so are settled in cash one day before the expiry.
Assume the expiration date on an options contract is Friday, March 22. The last trading is Thursday, March 21.
Unlike in India, in the US Futures can be cash-settled only one day prior to the expiry day. If the contract is taken to the expiry day, then are NO cash-settlements in the US. A seller of the future, to close the trade, will have to buy the product equal to the lot size traded. Similarly, a buyer of the Future will have to give away the stock from their Demat account to the buyer of the future to close the trade.
What is the Solution to Overcome This Issue?
To overcome this issue, traders in the US cancel out their trades by purchasing a covering position. This is what they will do. They will buy next month contract to cancel out an earlier sale (covering current month future short), or selling a next month future contract to liquidate an earlier purchase (covering long future).
The last trading day is the final day that a futures contract can be traded or closed out. Any contracts outstanding at the end of the last day trading day must be settled by delivery of the underlying physical asset, exchange of financial instruments, or by agreeing to a monetary settlement. The specific agreements covering these potential outcomes are contained in the futures contract specifications and vary between securities.
When the Sellers of Crude Oil were in Huge Profit so What is the Problem?
Remember that on expiry day a seller becomes a buyer. As a buyer, he/she would need to factor in the cost of transporting oil from the well to a shipping port, or a storage facility, where it may need to be held for up to six months, at significant cost. Or, if they are delivered oil already lying in a storage facility then they will have to pay the rent for the storage facility to the owners until the market for crude oil picks up so that they can sell and make a profit.
On top of that, they would also need to bet that oil prices will rise later this year to make a return on the “investment”. No oil company wants to “sell” their crude at a loss, so many producers are likely to shut their wells until the market recovers.
If the crude oil owner did not enter a future trade his loss is the production and storage of the oil until the demand for crude oil picks up. Add to this the interest rate loss equivalent to liquid funds in the US. When they finally start selling crude oil, to make a profit they will have to keep all these expenses in mind before finalizing the price.
More information on Crude Oil Future Trading in US
Did this have any implications?
Yes, it did. It means that the US Crude Oil producers were in a serious problem and were facing a glut. They knew that if they don’t stop drilling, they will have to give the oil away for free, and/or pay people to buy that oil.
Another Painful Point for Crude Oil Sellers
This oil is not trash/rubbish and therefore can not be dumped or disposed off in the sea or anywhere else since that will cause an environmental disaster and result in billions of dollars of penalty (Exxon Valdez Oil Spill, Deepwater Horizon oil spill, etc.)
Was There Any Other Problem For Crude Oil Sellers or This is The End?
Yes, there was another problem. The problem was drilling cannot be stopped as the cost of drilling is high & cannot be kept idle. If kept idle for long all the machinery to drill will need repairs involving millions of dollars.
I hope you now understand what went wrong with Crude Oil Future traders on Monday, 20-Apr-20, in the US. If you also traded on that day and if you were a Crude Oil Future Buyer in India – what happened to your trade. Please write in the comments section below.
This is the reason one should not trade in commodities, as the prices are unstable, very volatile and absolutely unpredictable which may results in huge losses for the traders.
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