In an ominous sign of supply and demand fundamentals in the crude oil market, the West Texas Intermediate (WTI) May 2020 contract closed on April 20, one day before its expiration, in negative territory, finishing the trading session at minus $36 per barrel. As contract holders tried to roll their position into the following month, the price continued to dive into negative territory. The weeks preceding the crash saw a record inflow of retail investment into several large crude oil exchange-traded funds. This drove open interest in the May futures contract to over 600,000 contracts, equivalent to 600 million barrels. As expiry for the May contract approached, large investors sold out of the May contracts and transferred their position to the contracts for delivery in future months (known as “rolling futures” in industry parlance), leaving under 200,000 contracts of open interest in the May contract. The day before the expiry date, the physical bid quickly evaporated, as buyers were hesitant to own the contract at expiry, fearing they would be forced and unable to take physical delivery in a market without immediately available storage capacity. As financial holders fled, the contract was left subject to the forces of pure physical supply and demand – and there was virtually no demand.
In environments where there are more modest differences between supply and demand, storage acts as a balancing mechanism between physical and financial markets by providing an outlet for excess supply when demand softens. What’s more, the terms of the WTI contract include a mechanism for physical settlement at Cushing, Oklahoma. When a near-term futures contract expires and its open interest “rolls” to the following month’s contract, traders who do not liquidate the contract before expiring must take physical delivery over the course of the month. The availability of storage acts as a balancing mechanism that links and brings equilibrium to physical commodity markets and their corresponding financial derivatives by allowing traders to take physical delivery of oil, theoretically leading to a convergence between futures and physical prices at contract expiry. Physical traders with the ability to take delivery of and store crude oil should have incentive to step in to buy close-to-expiry futures (at a small discount) from financial holders, earning a slight margin on the discount at which they buy the crude before taking delivery. This incentive could be heightened by the presence of a contango structure in the market, meaning the trader could take physical delivery over the month, pay storage, financing and insurance costs for a period of time, sell future-month contracts and still earn a margin. On April 20, the combination of a large open interest one day before expiry, the difficulty of securing storage at Cushing, which was filling open and largely “spoken for” under term contracts, and an extremely bleak demand picture led to a marketplace with many sellers and very few buyers, resulting in prices hitting negative territory.
When storage capacity is restricted – and with it, the ability to take delivery of crude oil against the futures contract – the stage is set for significant volatility at contract expiry. While Energy Information Administration (EIA) data reported the crude oil tank farm at Cushing was roughly 81% full on April 24, practically speaking, all of the remaining storage capacity in May has been leased by physical midstream or trading companies. Crude stored at Cushing on April 24 totaled approximately 61.2 million barrels, up nearly 80% since the start of 2020 and now rapidly approaching total storage capacity of 76 million barrels. The rate of storage growth at Cushing has been magnified relative to national growth in stocks due to its status as the physical delivery location for the WTI contract.