The Crude Report: Revisiting negative oil prices with the CFTC

Author Argus

It has been nearly one year since 20 April 2020, a turbulent day for oil markets when WTI crude prices fell to a settlement price of negative $37.63/bl, which left some producers in the unusual position of paying someone to take their oil.

Limited storage in Cushing, Oklahoma, and travel restrictions from Covid-19 both contributed to the volatile market dynamics that day, but others have sought a more robust "root cause" analysis to determine why oil prices fell so fast yet recovered so quickly the next day.

In this episode of The Crude Report, Commodity Futures Trading Commission member Dan Berkovitz offers his perspective on the dip into negative oil prices, the need to analyze the significant increase in "trading at settlement" contracts on 20 April, and his push for a more thorough review by regulators of market activity that day.

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Chris: Hello, and welcome to The Crude Report, Argus' weekly podcast series on global crude oil markets. This is Chris Knight and I'm a reporter who covers energy policy from Washington, D.C.

So today we're coming up on the 1-year anniversary of the day when the primary US benchmark for crude, the West Texas Intermediate (WTI) contract, fell to a negative price for the first time. And it wasn't a small drop but a $55/bl decline on April 20th, to settle at a price of negative $37/bl.

WTI front month price, at settlement
Source: Argus Media

To discuss what happened in oil markets on April 20th and then discuss the specialized oil contract used at high levels that day, we have commissioner Dan Berkovitz who is one of four members on the US Commodity Futures Trading Commission (CFTC). Commissioner Berkovitz, thank you for joining us.

Dan: Thank you, Chris. It's a pleasure to be here today. Thank you.

Chris: To set things up a bit, the West Texas Intermediate contract, or WTI, is a specific grade of light sweet crude and its main contract is based on activity in Cushing, Oklahoma. Commissioner Berkovitz, can you give us a quick sense of why the WTI contract is so important in the world of oil, and also how it can have effects outside of oil markets?

Dan: Well thank you Chris. And our benchmark, as you've noted, the WTI contract, is a global benchmark used around the world. Even though WTI itself is a crude oil particularly to Texas, over the years, it has grown into a global benchmark and is used by traders all around the world as a pricing reference for light sweet crude. Now that the US is a significant exporter of crude oil, that has only increased its global significance.

Chris: And usually, you know, we see the price of the WTI contract change by 50¢. On a big day, it might change $3 or $4. As someone sitting on the regulatory side or someone who's just been watching oil markets for a while, what's the significance of a $55 drop in a single day? Tell me what that looks like on your end?

Dan: Well this was totally unprecedented – a really historic day in the oil markets, in terms of the $55 drop. Just a few months prior to that, oil had been trading $65, $60/bl – that was the price of oil. And you're correct, we may see some differentials or even dollar differentials on a significant day, but to have a $55/day drop...excuse me, $55/bl drop in one day was truly something off the charts that we hadn't seen before. And there was also, we could talk about further too, a significant disconnect between the futures markets and the other derivative markets, and the physical market as well, associated with that significant price change.

Chris: There's been a lot of stories written about what might've caused WTI prices to drop so much. There were factors like limited storage capacity in Cushing, increased production, the effects of Covid-19. And the CFTC had its own interim report they put out in late November, but you said that report was inadequate and incomplete. Could you describe briefly what you'd like to see more coming out of the CFTC on reviewing that?

Dan: Sure. So what the report did that we put out was basically set the conditions for what happened around that time of year. The report talked about general macroeconomic conditions, the supply conditions generally, and the demand conditions in the market at that time. And, as you recall, and we're still in somewhat of a Covid-stressed period but, back then, this was April, the world had basically gone into a lockdown in March and supply was still basically the production that had occurred over the past few months pre-pandemic, but then the demand drop off was really absolutely also unprecedented. Airplanes stopped flying, people stopped traveling, people didn't commute to work anymore. So the gasoline demand was way down, industrial demand was down too. So there were very unique supply/demand conditions at that time, about a year ago, which created this tremendous imbalance.

But, so that really was the stage for what happened at the expiration on April 20th of last year. What I would like to see, given the magnitude of the price drop on that, it's not only the magnitude of the price drop on that one today but it's the rebound the next day. And, as I mentioned before, it's also the disconnect between the futures markets and the physical markets, as well as the futures market and other derivative markets, on that day. So the disconnect between the WTI price and other derivatives in the physical market is actually, I believe, a very significant fact, not necessarily just the absolute magnitude. The absolute magnitude is, obviously, an important indicator, but it's that disconnect that I think we need to really get to the bottom of. And looking at the macro, why there was volatility in the market is very helpful background but it doesn't really explain exactly what happened that day.

And the report itself acknowledges that. The report itself says, "This is not a root-cause analysis." So I was disappointed in the report at the time, and I hope that we'll be able to provide an explanation of exactly what happened in the future.

Chris: So you focus in particular on some statements that you released publicly, on a type of contract called trading at settlement, or TAS. I actually wasn't familiar with this type of contract before, I read some of your statements. So, could you walk us through what TAS is and why trader might wanna use it?

Dan: Sure. So trading at settlement, it's a futures contract and it's a particular order type. So normally if you go and buy a futures contract, you'll see the price posted at, you know, $55/bl, and you'll put in a bid to buy it at $55/bl, that's the price that's shown on the board at the time, or on your computer at the time. Trading at settlement is a useful mechanism for a lot of traders who don't necessarily want the price if you're trading at 10 in the morning and the final contract price settles at 2:30 in the afternoon. And you've got a contract in the physical market, you're a producer or a supplier or a purchaser or whatever, refiner, and your physical contract is tied to the settlement price of WTI and you wanna get, from the futures market, a price as close to the settlement price as you can possibly get. Because that's what your physical price is.

So, there's a mechanism that the exchanges have, it's been a very useful mechanism, called trading at settlement where you don't get the price on the board, like at 10 in the morning. As you put in your bid, you say, "I want the price, the settlement price," and you can say, "I'll take the settlement price plus a tick or plus two ticks or less than a tick." There's slight variations off the settlement price. So you get the settlement price and that enables you to get extremely accurate hedges for your physical contracts.

So, the TAS contract is priced off the settlement price, rather than an outright price that you'll see on the board. And it's useful. It's in a number of products, it's used in agricultural products and it's used in the energy markets as well. So, that's basically what the TAS contract is.

Chris: And you talked about, you know, in the past, the CFTC has brought enforcement actions related to the TAS contract. You noted that trading was particularly high in this type of contract on April 20th. How can someone use this type of contract in a way that doesn't comply with the commission's rules?

Dan: So immediately, right after the event happened, there were a number of press reports indicating that TAS, trading at settlement, was used to a large degree on April 20th. That there was a big presence of TAS contracts. And our report that we did, the interim report that we were talking about just a minute ago, the statistics we did put ou, in that report, statistics on TAS trading on that day. And it was a very very unusual day in terms of the amount of TAS trading. So our report did confirm the public reports that there was a lot of TAS trading on April 20th. What our report didn't do was analyze the effect of the TAS trading.

Now the problem with TAS, or the potential problem with TAS, that we had – we had two manipulation cases. An attempted manipulation case on TAS is, typically, if you have, for example, a spread contract, you have a long and a short in the same commodity maybe in different months. You're both long and short at the same time, so, if you were to try to manipulate, you buy, you may try to push up the price by buying a lot. But then, eventually, you have to sell so you're gonna push down the price. So, there's a symmetry on a normal spread contract between the buy and the sell, which makes it much more difficult. I won't say impossible but it makes it harder to manipulate through buying and selling.

On TAS contracts though, the TAS, you know, is not priced until the settlement. So, if you go long TAS, for example, so you bought a contract, you're going long, you pay and the price that you will pay will be determined at the settlement. Now, on the other hand, throughout the day, before you get there, you start selling a lot of outright contracts. So, the more you sell presumably, typically, a selling of a contract will have an impact on price, especially when liquidity is getting less and less, as tends to happen in a contract as it goes towards settlement, so you're selling throughout the day going short and you've got the long contract you're gonna buy at the end of the day. So as you're buying through the day, you're helping the price go down through your sales, which, ultimately, is pushing down the price that you're gonna buy it at the end of the day.

So you end up selling high, buying low. And it's a mechanism that has been used in that manner intentionally. We've brought the two cases on it. The CME has issued a market advisory notice saying, "We're watching, don't abuse the TAS process." So, it's a mechanism that we know can be abused. It's a useful mechanism but because of the way it's leg is not priced until settlement, the other leg is priced at the market price when the transaction occurs. It creates this potential for abuse and artificial pricing throughout the day. So, it's something that has to be watched very carefully and, given the prevalence of its use on April 20th, I'd like us to see an analysis of exactly what happened in that regard.

Chris: And is this something that the CFTC can pull up data on trading and figure out whether it happened retroactively? Basically the data already exists, you just have to analyze it to see if...

Dan: Correct. Correct. Correct, we have to analyze the data but it's not necessarily so simple as just looking at spreadsheets. I mean you really have to, you know, talk to market participants, and a variety of market participants, and understand the liquidity at the time and what was going on at the various times. Getting the data is absolutely critical and there's know, unless you have the trade plotters or whatever, you can't really determine it. But it also requires more than just data analytics.

Chris: And, so, you know, we've been talking about, kind of looking at that type of contact on the back end, is there anything the CFTC or exchanges could do on the front end to make it harder for traders to use the TAS in an improper way?

Dan: Well, I've been know, we just did our position limits rule, our multi-year effort, to update the position limits rules required by the Dodd-Frank Act. And the rule, the new revised rule went into effect March 15th. I expressed concern, at the time, last year, that the TAS, because of this potential, that there should be a limit on the speculative use of TAS. As I mentioned, TAS is a very useful mechanism for hedgers because you can get through the futures market the exact price that your physical contracts are priced at the settlement price. But I've asked the question, to which I haven't received, in my view, a satisfactory answer, is, "Okay, TAS for hedging is appropriate and needed. But why do we need unlimited use of TAS by speculators because of this very potential for either intentional or unintentional artificial prices?" It's not just somebody can go in and, as we see in our examples, try to push the price through use of TAS. And the examples we have actually were not...the numbers of the contracts that they did it through were not way above the position limits, one was slightly above the position limits but one was even within it, so, you don't need to exceed position limits actually for it to be a potential problem. But right now there's no limit on it. There's no speculative limit on the use of TAS contracts. And because, I believe, of its relatively unique properties where it creates this asymmetry in the pricing, that you can push the price and yet be the net zero, you've got a short contract outright and a long contract TAS, and, under our position limits rules, those net out. Your position is even. Why can't we put on a speculative limit on that is a question I haven't had the answer to. So, I think we should have speculative limits on TAS and allow it, you know, for hedgers, if they need it, they come in and they get a hedge exemption. And, so, I think our rules can accommodate that. So, that's what I'd like to see us potentially move in the future.

Chris: And I think, this will probably be my last question, going back to the interim report that came out in November, you said at the time that you thought it was really important for the commission to put out a full and complete report on what happened. I think there's probably a temptation by a lot of people to say, "Hey, negative prices were a fluke. It was caused by a once-in-a-century pandemic." What's the need to act quickly and to have the CFTC definitively come out and say, "Here's what happened"?

Dan: Well, I think one of the strengths of our markets is the confidence in the integrity of our markets that people around the world have. We started this interview talking about WTI as a global benchmark. And I get asked that question, "Well, why is WTI the global benchmark?" But one reason is people have confidence in the contract. And they know it's a well-regulated contract and they know there's a cop on the beat. They know that, if you trust your money to the U.S. derivative markets, that there are customer protections, there's market integrity, and there's somebody doing surveillance. And there are rules to prevent general abuse, you don't think you're gonna, you know, taken, that you're gonna get a fair price. And so part of the reason for the success of the contract is the integrity of the contract.

Now, to the extent that...well, this is a once-in-a-hundred-year pandemic, that's true, but we've had, just in the past year, we've had 100-year events in a number of areas. We had a 100-year pandemic, last year, we had 100-year fires in California, we just had a 100-year cold coming down in the Midwest, there was disruptions in the Texas electricity market. One of the functions of the market and the strengths of the market and why people hedge is to protect against these extreme events. So, the markets have to be able to withstand extreme events, as well as normal events. And what we may think as a 100-year event, really I've been in the market a while and I think there's a lot of folks in the market...I remember doing a natural-gas investigation, an Amaranth case, and I did the data about the price fluctuations caused by Amaranth trading, large trading in the natural-gas market. And I remarked to one trader looking at the data, "This is a six-sigma event." And his response to me was, "We see six-sigma events every other day here in the natural-gas market."

So, I think we need to understand what happened and then we need to work with the exchanges and the affected stakeholders, the traders, to put rules in place that will enable the important function of hedging to continue, that hedgers can use this mechanism to meet their contractual needs, at the same time, put in sensible protections against potential abuse. So it's protecting everybody in the market in the times when it most needs the protection in stressed conditions is really when you wanna be able to rely on a market. And sure that, yes, if you put on a hedge and you've got a contract on expiration and a hedge in a time of market stress, that you're gonna get a settlement price that's reflective of supply and demand, not a settlement price that's gonna be reflective of some potentially price artificiality. So, I think it's important, even in the rare events, that the markets have integrity and reliability.

Chris: Well, thank you so much for taking the time to talk to us.

Dan: Thank you, Chris. Appreciate it very much.

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