LONDON (Reuters) – Brent oil futures are set for extreme volatility when the front-month June contract expires next week, but they will avoid the historic plunge below zero that U.S. peer WTI has suffered, traders and analysts said.
FILE PHOTO: A pump jack operates in the Permian Basin oil production area near Wink, Texas U.S. August 22, 2018. Picture taken August 22, 2018. REUTERS/Nick Oxford
West Texas Intermediate futures CLc1 turned negative for the first time ever on Monday, touching a low of minus $40.32 a barrel before closing at minus $37.63 a barrel.
The frenzied selling was driven by a lack of storage space to hold a glut of crude, meaning traders were willing to pay buyers to take oil off their hands.
The surplus is a result of lockdowns to try to contain the coronavirus pandemic that have wiped out nearly a third of the world’s daily oil demand.
For Brent, the global benchmark, the impact is likely to be less because of differences in how the contract is settled.
While WTI plummeted below zero, Europe’s Brent oil futures LCOc1 stayed around the mid-$20s a barrel. On Tuesday, Brent was around $20 a barrel.
WHAT IS CONTRACT EXPIRY?
An oil futures contract expires once a month. Market participants either close positions, making or losing money depending on when they bought in, or they roll their interest into the following month.
WTI contracts are settled with physical barrels, while Brent is settled with cash.
WTI expires late on Tuesday and Brent will expire on April 30.
WHAT HAPPENS AT EXPIRY?
When the WTI contract expires, a quantity of oil that previously existed only on paper is converted into physical barrels that need to be used or else stored at a major U.S. storage site tied to the contract at Cushing, Oklahoma.
On expiry day, a market participant in WTI has three choices:
1) Let the contract expire and take delivery of physical oil;
2) Reverse out, or sell the current month’s contract to somebody else;
3) Roll over, or close the current contract by buying one for the following month.
WHY PAY SOMEONE TO TAKE YOUR OIL?
Many market participants in futures are not physical traders and cannot handle cargoes, which has become a major issue as oil infrastructure globally is full to the brim because of demand destruction.
“Essentially, with 108 million barrels worth of contract positions still not closed by the traders in the market, the buyers were rushing for the door to avoid taking physical delivery of crude,” Rystad said in a note, referring to Monday’s price slide ahead of Tuesday’s contract expiry.
When WTI hit minus $40 a barrel, anyone rolling over at that point would have lost about $60 a barrel – the initial May value at around $20 and paying someone $40 to take it.
IS BRENT ALSO SET FOR DEEPER FALLS?
Brent contracts are settled in cash so there is no risk of going negative but they could drop significantly.
“Nobody will pay you to take cash but they will pay you to take the oil they cannot handle,” said one senior industry source, asking not to be named. “Brent is an indicator for sentiment rather than a physical metric.”
Brent future contract holders are concerned about the disconnect with the physical market.
For about a month, there has been a record gap between futures and the underlying physical Dated Brent benchmark, used to trade more than half the world’s physical crude cargoes. IHBFO-DTD
Dated Brent represents the baseline price that refineries and other physical buyers are willing to pay. Individual crude grades are then priced at differentials to that benchmark.
Dated Brent is typically worth up to $2 more or less than the futures price but against the backdrop of so much oversupply it widened last week to more than $10 a barrel. The extent of the gap implies a downward correction is inevitable.
“We are not talking about Brent futures replicating WTI and falling into negative territory, as unlike WTI, Brent is cash-settled, while seaborne grades have more storage outlets, but a closer alignment with physical prices is clearly a possibility,” consultancy JBC Energy said in a note.
Reporting by Julia Payne; editing by Barbara Lewis