Of all the things that happened in April, it had to be the crash in oil futures that best represents what keeps a trader up at night. On April 20th, crude oil futures for May delivery settled at NEGATIVE $37.63 per barrel. That’s right, if you were on the hook to have a barrel of crude oil delivered to you then you actually had to pay someone $37.63 per barrel to divert that barrel elsewhere since most HOAs won’t let you pile up full oil barrels in your backyard.
This situation came about due to a confluence of events. It was kicked off by the Saudi and Russia imbroglio. Saudi and Russia kept pumping oil trying to steal market share and cause each other pain via petro-state budgetary problems. The side effect was that a bunch of oil consumers and speculators started leasing storage capacity for all the crude oil that was being sold at ultra-low prices. They couldn’t use it immediately but they figured prices would eventually go back up so they thought they’d take delivery of physical crude oil and then use it as they needed it or sell it to someone who did.
Eventually that storage capacity largely ran out.
Then the pandemic hit.
What was supposed to be a temporary price war has now turned into something much more damaging for every petro-state out there.
But I’m not terribly concerned about petro-state price wars or the realpolitik that is going on. What I’m interested in is a situation that hasn’t been seen before and wasn’t supposed to happen.
Oil prices’ zero bound
I doubt there is a trading or valuation model out there that had the ability to have an outcome where an oil contract settled below zero. The same assumption used to be true of interest rates. As a trader or investor you’re always thinking “What’s the lowest this could possibly go if something crazy happened?” Depending on whether you’re a fundamental investor or a quant, you’re going to say something like “$20 a barrel is the lowest it went back during the Great Recession” or “A 6 standard deviation decline would put it around $25.”
If you’re being intellectually honest with yourself, you’d probably add as an afterthought: “Well, I guess it could always go to zero.”
There may have been some professionals out there that contemplated the fun thought experiment that included an inability to take delivery and how they’d get out of it, but it’s hard to imagine they did that in a market as big, liquid, and necessary as crude oil.
Save me from ignorance
There’s a ton of fun ways to lose money as a trader. A lot of those ways you’ll be intimately familiar with: sequence of return risk, unexpected news, lack of diversification, or too much leverage.
What creates the biggest blow-ups are the things that we think are true but turn out not to be. Long-Term Capital Management is the classic schadenfreude. A bunch of absolute geniuses thought they had figured out how the markets worked but it turns out their formulas were a bit off and couldn’t handle a hiccup because of the amount of leverage they were using. That hiccup almost took down the global economy.
Another example is anyone that went as long as possible with as much leverage as possible when German bunds hit the zero bound for the first time in 50 years. And then watched them go lower.
And every now and then there are stocks that spike 944 percent in a single day for apparently no reason. If you’re short in any big way, you’re done.
And quite possibly there was some retail trader (or even a professional) who started buying May crude oil futures contracts when it hit the zero bound hoping to make a quick buck as they “inevitably” bounced back.
In some ways the pandemic and the government response to it is new territory. States may be allowed to declare bankruptcy. The US government may default on its obligations. We might find a universal flu vaccine.
But the thing every trader and investor should probably start thinking more about is which positions and trades may be subject to an extreme event, one that was previously thought impossible.
The solution isn’t to avoid the trade or investment, but to think what your portfolio would do if the impossible happened. Maybe reduce the position size. Maybe buy a hedge that’s so far out of the money and is so impossible to hit that it’s practically free.
Because as April just proved once again, the impossible occasionally happens.