The Rise of Retail and the Fall of WTI

The long-term impact of the Covid-19 crisis on various industries, including oil trading, remains highly uncertain. While some uncertainties, such as the magnitude of the demand destruction for petroleum products and the pace of global storage saturation are known unknowns, other consequences could come as a shocking surprise. It is very unlikely that any of us could have foreseen WTI ever trading at negative 40 dollars, and the critical role that retail-oriented derivatives products played in such historic event. To better understand what happened with the recent behavior of WTI, this Comment analyses how financial participation in oil markets evolved over the last decade, particularly the rise of the retail investor and the role of Exchange Traded Funds (ETFs) in the historic event of oil prices dropping to negative $40 on the day before the expiry of May WTI futures.

The Comment argues that while long-only ETFs always provide significant downward pressure on prompt WTI contracts as traders sell in anticipation of the product rolls, these funds did not have anything to do with negative pricing.  Also, contrary to often cited opinions, this episode was not directly caused by well-documented storage issues in WTI contract delivery location. The lack of storage was indeed the catalyst that started the fire. Subsequently, large ETFs, including USO, added some fuel to it by rolling their massive positions and pressuring May WTI by the middle of April. But the actual explosion and subsequent $60 collapse in a single day down to minus $40 was caused by small cousins within ETF family, which happened at the time when all large market participants already left the contract.

Longer term, a growing appetite among smaller retail investors to participate in the market supported by easier access to trading platforms and modern technology does not appear to be going away. Even fifteen years of losses by financial oil investors have not been able to eliminate the paper demand for oil. Financial engineering will adjust and make products better, but they are unlikely to disappear anytime soon and tracking their positions becomes as important to oil analysts as tracking fundamental balances.

As such, investors ongoing inflows will likely increase opportunities for US producers to place forward hedges at levels which can still ensure reasonable longer-term returns. Somewhat ‘irrational’ behavior among retail investors effectively subsidizes producer hedging and could delay fundamental market rebalancing if producers choose to take this opportunity and to hedge, instead of making more rational decisions to cut production. Ironically, one wrong business model prevents the other one from getting better at least until the invisible hand of free markets punishes both.

The Comment concludes that the sharp blow inflicted by the collapse of May contract will not be repeated given some additional safeguards which have been put in place by dealers improving systems to handle negative prices, by prime brokers raising initial margins, by regulators asking funds to reduce positions, and by funds themselves rolling out of prompt WTI contract earlier. But ongoing dull pain inflicted on both investors and oil producers is there to stay longer.

By: Ilia Bouchouev