Future(s) Games - How the Futures Market Impacts Physical Crude Oil

On Monday, front-month WTI at Cushing cratered to a negative $37.63/bbl. On Tuesday, the same futures price rose by nearly $48 to close at about $10/bbl — a positive $10, that is. As for WTI to be delivered in June, it lost well over a third of its value on Tuesday, ending up at less than $12/bbl, but over the past two days it has roared back to over $16/bbl. No doubt the WTI futures market will see more wild times in the days and weeks ahead as traders look to avoid the traps that ensnared the market as the May contract approached expiry. If there’s a lesson to be learned from the past week, it’s that it really helps to understand the ins and outs of the futures market — especially when it is so volatile. Perhaps the most important thing to wrap your head around is that while the futures market mostly involves financial players who will never take physical delivery of oil, the two markets — financial and physical — are fundamentally linked. Prompt-month futures converge on spot prices over time, while physical contracts are settled in part based on NYMEX futures, so producers will feel the sting of Monday’s negative prices when physical April deliveries are invoiced. Today, we begin a two-part blog series examining U.S. spot crude pricing mechanisms.

The Chicago Mercantile Exchange (CME) NYMEX (formerly New York Mercantile Exchange, or “Merc”) WTI is the most liquid (widely and actively traded) commodity futures contract in the world. So far this year, the market has traded more than 1.5 billion barrels per day of crude across all delivery months for the contract and on Tuesday that volume spiked to over 4 billion barrels. The NYMEX WTI crude price is so ubiquitous that it also underpins the domestic U.S. crude spot market. At the same time, futures traders must be mindful of what happens in the spot market. In a strange symbiotic relationship, not only do cash crude prices heavily influence futures prices, but the cash price for most U.S. crude is indexed to the futures price. Sort of a “do-loop”, for you programmers. Differences between futures and physical trading, as well as the delivery mechanism that links the two markets, make pricing physical WTI complicated.

At various points throughout RBN’s history, we’ve asked the question whether a U.S. crude price could be based on anything other than the West Texas Intermediate (WTI) benchmark at Cushing, OK. We asked that question in our eight-part Oklahoma Swing blog series and Drill Down Report, and most recently in a blog considering new projects around the hub, the aptly named That Was Then, This Is Now. Our answer to that question has always been a resounding “no” –– Cushing will almost certainly retain its benchmark status for as far out as the eye can see. WTI will remain dominant, largely because of its role as the benchmark delivery grade for the Cushing CME/NYMEX crude futures contract. [Any crude stream that meets the product specifications for Light Sweet Crude Oil as defined in the NYMEX Rulebook Chapter 200 can be delivered against the NYMEX contract, as long as they can be physically delivered at Cushing. We detailed CME/NYMEX quality specifications versus the Houston competition — Magellan East Houston (MEH) –– specs in The Race is On.] As a result, the daily settlement price or “close” for the nearby NYMEX crude futures contract acts as the benchmark price for the U.S. domestic crude oil spot market.