The coronavirus outbreak has had significant ramifications for the global financial system. Recently, the seemingly impossible became a reality: the price of crude oil, a valuable worldwide commodity, went negative. These events leave experts pondering if a black swan event is imminent.
The 1-for-8 Reverse Split
On Tuesday, April 28th, the United States Oil Fund (USO), the largest Crude Oil ETP, executed the 1-for-8 split of its stock. A reverse stock split is essentially when a company consolidates many shares into one. In the case of USO, the stockholder will have one share for every eight shares they held earlier, leaving the dollar value of the share the same. USO employs this strategy in order to try and raise the price of its stock from roughly $2.50 to $20.00. Intuitively, $2.50 per share multiplied by 8, the number of shares being consolidated, produces $20.00, which is the expected contract price. The average trader will perceive that the contract price has increased significantly, which will encourage many to invest.
What is Happening to USO?
As the coronavirus became ever-global, and stay-at-home orders were introduced, the demand for gasoline plummeted. With few driving or consuming gasoline, the demand in the United States fell from 10 million to 6 million barrels a day. 518 million barrels of oil are currently being held in storage and facilities are running at 86% of their capacity. The United States government mandates that wells operate at 60% capacity or higher. If a given well falls below the authorized capacity level, producers may damage and jeopardize the safety of the well. The producers prefer to operate at the minimum threshold due to the financial burden of ceasing production altogether. Although the amount of storage for crude oil is predicted to be naught by the middle of May, producers continue to produce crude oil because they are selling their futures contracts. The oil, as well as the storage for the oil, subsequently, becomes the responsibility of the USO holder.
Oil markets are currently in a super contango, a state in which futures at later dates trade at higher prices than futures at nearer dates. Essentially, people will either have to sell their oil ETPs for a low price or find storage for the oil once the contract expires, which is scarce and expensive. Storage prices will continue to rise as it becomes increasingly difficult to find. The producers of crude oil will continue to produce, as the contract holds that the buyers have a responsibility to go forward with the delivery and find storage. The producers are further exacerbating the issue by short selling futures contracts to the USO ETP, which shifts the burden onto the buyer of the futures contracts. Nonetheless, producers will continue to sell oil in the futures market because they are able to lock in their desired price. Producers are further incentivized by government administrations who will encourage production to halt widespread defaults.
Negative Prices & The Result
In due course, storage tanks will be full and there will be few buyers of contracts, regardless of if they are $10 to $12 cheaper than the price of a contract in the upcoming months. As long as there is a supply and demand imbalance for the oil market, the price of the contract may continue to fall until it reaches zero or even goes negative. Investors may run the risk of a loss that continues to build if they hold the belief that ETPs are capped at zero. If the price falls negative, however, the futures buyers will not pay to cover the losses; responsibility will lie with managers or brokers of funds who will then try to get out of these trades. USO may get a margin call, which occurs in cases where accounts decrease below the maintenance margin level. The broker will be forced to sell USO’s unsustainable contracts to liquidate the fund, but there will be no buyers of the contracts, and USO holds roughly 25% of the market. A financial crisis or black swan event may be in the midst, as the design of the futures market does not incorporate such events.
What is a Black Swan Event?
A black swan event is an unpredictable, rare event with profound negative consequences for an economy. As an economy plummets, cyclical industries incur immense financial loss, which can result in companies filing for bankruptcy.
