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Oil Traders Not Sure They Like Oil

Money Stuff
Bloomberg

Oil

It will be a little weird if the price of oil goes negative next month. I mean, it could happen; it happened this month. The last trade of the NYMEX June West Texas Intermediate crude oil future will be on May 19; anyone long June futures after that will have to take delivery of a bunch of oil in June in Cushing, Oklahoma, where there is not a lot of space to store oil. The last trade of the May WTI futures was on April 21, and on April 20, as financial traders with long positions scrambled to get out of the contract, the price fell to negative $37.63 per barrel. Then on April 21 it was fine again, and the contract finished at $10.01. Even on April 20, most trades in the May futures happened at positive prices. But toward the end of the day, panic—or something—set in, and for a short period people were paying to get rid of their oil futures.

The June futures contract, meanwhile, was in the $20s all day that day; the next day it fell a lot, hitting $11.57, still a significantly positive number. Yesterday's closing price was $12.78; this morning it fell to just above $10, and then recovered some. If you own June oil you still have a few weeks to get out of it without taking delivery, but the whole point of financial markets is to do this sort of backward induction. If on May 19 everyone is going to be panicking and selling June oil contracts for negative $37, then on May 18 you should not buy those contracts for much more than negative $37, which means that on May 17 you should not, etc., so the price should be negative now. The price is not negative now. This implies not only that futures traders, who want to own only abstract paper oil, think that that oil is worth $12 or whatever, but also that they expect that, as May 19 rolls around and that abstract paper oil is converted into physical oil, it will still be worth a positive number of dollars. 

In other words the June futures prices imply that what happened last week was most likely an anomaly: not "oil has negative value and you need to pay people to get rid of it," but rather "in the last few hours of trading some naive traders had to get out of paper positions and the market held them up for it."

Now, that said, the price of June oil is very low, and also very far below the price of July oil. And markets are doing the backward induction. Financial investors who would ordinarily own the June contracts, but who do not want to be stuck with oil when they expire, are getting out of them early:

S&P Global Inc., the company behind the most popular commodity index, told clients to roll all their exposure out of the West Texas Intermediate crude oil futures for June into July with immediate effect, triggering a big drop in oil prices.

"This unscheduled roll is being implemented based on the potential for the June 2020 WTI Crude Oil contract to price at or below zero as well as the steady decline in open interest for the June 2020 contract," the company said in a notice seen by Bloomberg News. 

And:

"We are seeing the exodus away from the Nymex WTI June contract growing," said BNP Paribas' head of commodity-markets strategy Harry Tchilinguirian. The move is "still motivated by the risk of negative prices that can emerge with the testing of storage capacity limits at Cushing," the U.S. storage hub in Oklahoma.

If you are afraid of having to take delivery of oil in June, the time to sell out of your June contract is now, not May 18. Some number of investors who are afraid of having to take delivery of oil are selling now, rather than waiting for the last minute to roll their contracts as they ordinarily would. Of course if they all do that this week then there'll be no special panic or selling pressure on May 18, and the price won't go negative. One possible reason the price went negative last week was that no one really anticipated it going negative, so too many investors were bunched in the May contract as it neared expiration. Now that you know it's a risk, you're more likely to get out early.

Though arguably another reason that the price went negative last week is that people did anticipate it. Or rather, they didn't, then they did: Negative oil prices were unthinkable, and then the exchange ran a computer test to make sure that systems could handle negative prices, and after that all anyone could think about were negative oil prices. If everyone in the market thinks about a price all at once, that price tends to materialize. Here's Bloomberg's fascinating recap of "The 20 Minutes That Broke the U.S. Oil Market":

Yet on April 15, CME offered clients the ability to test their systems to prepare for negativity. That's when the market really woke up to the idea that this could actually happen, said Clay Davis, a principal at Verano Energy Trading LP in Houston.

One important point in that story is that most big financial investors had gotten out of the May oil futures before they went negative. What happened last Monday was not a last-minute stampede of big exchange-traded funds out of the May futures; it was a relatively small number of investors stuck in the contract after everyone else got out.[1] For instance there was a Chinese retail "product that the state-run Bank of China dubbed Yuan You Bao, or Crude Oil Treasure":

Many things about the explosive, flash-crash-like nature of the sell-off are still not fully understood, including how big a role the Crude Oil Treasure fund played as it sought to get out of the May contracts hours before they expired (and which other investors found themselves in the same position). …

For small-time investors in Asia like A'Xiang who bet enthusiastically on oil, though, it has been a reckoning.

She awoke to a text at 6 a.m. from Bank of China informing her that not only had their savings been lost but that she and her boyfriend may actually owe money.

"When we saw the oil price start plunging, we were prepared that our money may be all gone," she said. They hadn't understood, she said, what they were getting into. "It didn't occur to us that we had to pay attention to the overseas futures price and the whole concept of contract rolling."

In all, there were some 3,700 retail investors in Bank of China's Crude Oil Treasure fund. Collectively, they lost $85 million.

U.S. oil ETFs can't go negative—that is, the fund can't come after its investors if it ends up owing money—but I suppose that is not universally true of retail oil futures products, oops. 

The article points to other anomaly-type explanations for last week's negative prices. ("The trading at settlement mechanism failed," etc.) But there are certainly also fundamental concerns. Here is "The Next Chapter of the Oil Crisis: The Industry Shuts Down," and you don't shut down an industry because of a temporary financial-markets anomaly:

The best indicator of how the U.S. industry is reacting is the rapid drop in the number of oil rigs in operation, which last week fell to a four-year low. Before the coronavirus crisis hit, oil companies ran about 650 rigs in the U.S. By Friday, more than 40% of them had stopped working, with only 378 left.

"Monday really focused people's minds that production needs to slow down," Ben Luckock, co-head of oil trading at commodity merchant Trafigura Group, said. "It's the smack in the face the market needed to realize this is serious." …

Before the crisis hit, the world was consuming about 100 million barrels a day. Demand now, however, is somewhere between 65 and 70 million barrels. So, in a worst-case scenario, about a third of global output needs to be shut.

And it's not just retail investors in goofy financial products who are getting negative prices for oil; actual oil producers are too:

The price shock has been particularly intense in the physical market: producers of crude streams such as South Texas Sour and Eastern Kansas Common had to pay more than $50 a barrel to offload their output last week. ConocoPhillips and shale producer Continental Resources Inc. have all announced plans to shut in output. Regulators in Oklahoma voted to allow oil drillers to shut wells without losing leases; New Mexico made a similar decision.

And while June oil futures prices are still positive and normal-ish, options prices are a little weird. Bloomberg tells me that you can buy a June WTI put option struck at $1 for $1.46.[2] That is an unusual price! The put option gives you the option to sell oil, at expiration, for $1. Ordinarily the most you would pay for that is a little less than $1: The most you'd ordinarily get back on your option is $1, which you'd get at expiration if oil prices were zero. Today you have to pay $1.46. The only way you can make money is if oil prices are negative at expiration. There is trading in this contract. There's even more trading in the $0.50 strike contract (ask price of around $1.20), an even purer bet that oil is going below zero.[3] It would be strange if, next month, the oil market is again unable to digest the futures expiration, and prices again go negative. But stranger things have happened, and people are getting ready for it.

Ebitda

Banks and other lenders tend to evaluate companies' creditworthiness using leverage ratios. For lots of companies the most relevant ratio is debt to Ebitda (earnings before interest, taxes, depreciation and amortization). Companies with debt of one times Ebitda are generally pretty safe—roughly speaking they can pay back their debt out of cash flow in a year—while companies with debt of eight times Ebitda are generally pretty risk. There are rough cut-offs, rules of thumb. They get incorporated into credit agreements: Borrowers agree to keep their debt under some integer multiple of Ebitda, because the lenders want certain risk characteristics, and a company with a leverage ratio of 4.1x is a different category of risk from one with 3.9x.

And now the U.S. Treasury and the Federal Reserve are going to lend money directly to mid-sized companies in their Main Street Lending Program. And they will incorporate rough leverage-ratio rules of thumb taken, roughly, from the private sector: Two different Main Street facilities are capped at 4x Ebitda and 6x Ebitda.

But there is a small error of translation. Here's Robert Armstrong at the Financial Times:

The problem, according to executives and analysts, is the definition of ebitda, a measure of profit that stands for "earnings before interest, taxes, depreciation and amortisation". MSLP rules limit recipients of the government-backed loans to total debt, including MSLP borrowing, of either four or six times ebitda, depending on the loan type.

But ebitda as defined in loan agreements often excludes a number of expenses in addition to the four included in the acronym. Which costs are cut out varies by industry, bank and borrower. Common exclusions include restructuring and merger integration costs as well as stock compensation expenses.

Imposing the standard definition would mean that many mid-market companies already have more leverage than the programme allows, lending industry insiders say.

Ian Walker of Covenant Review, a credit research firm, looked at every company that has issued a term loan in the past 12 months, and found that 90 per cent of them already had debt of greater than four times standard or "as reported" ebitda. A third had greater than six times reported ebitda. 

"Of all the companies I have talked to, not one would meet the leverage rules," said a lawyer at a major Wall Street firm. A third of the midsized businesses in the US are owned by private equity and virtually all of these would exceed the leverage limits, the lawyer noted, adding that the Fed "has been told about the ebitda problem multiple times".

See, private credit agreements cap leverage at four or six or whatever times Ebitda, but "Ebitda," in those agreements, doesn't mean Ebitda. It doesn't mean earnings before interest, taxes, depreciation and amortization. It means earnings before those things and anything else that the company and its banks agree to strip out.

Dave Zion, of Zion Research, said that the definition of ebitda in loan agreements could run to thousands of words. "Sometimes they might as well skip all the other letters and just use "r", for revenue," he said.

Actually even that is generous. Since the coronavirus there have been loan covenants that calculate 2020 Ebitda using (normal, higher) 2019 revenue, meaning that there may be some companies whose 2020 Ebitda, for covenant compliance purposes, will be higher than their revenue. "Earnings before 2020," really.

The point is that there are companies out there who think that their leverage ratio is 3.5x, and their bankers say that their leverage ratio is 3.5x, and everyone agrees that they are the sort of company, and the sort of credit risk, that is represented by a 3.5x leverage ratio, but if you were to actually do the arithmetic of dividing their debt by their Ebitda you would get, like, 4.8x. And all those companies will go to the Fed and be like "we are a 3.5x levered company, can we have money," and the Fed will take out its calculators and say "wait no you are a 4.8x levered company so you can't," and there will be much disappointment.

If you build a financial system around a generally accepted fiction it can work fine; the trick is just to make sure that everyone understands and accepts the fiction. But then if someone new shows up—someone with all the money—and they are not part of the game, not used to the fiction, then it stops working.

What is Elon Musk up to?

Here, via Jim Chanos on Twitter, is a magnificent paragraph from Tesla Inc.'s Form 10-K filed today:

Tesla determined not to renew its directors and officers liability insurance policy for the 2019-2020 year due to disproportionately high premiums quoted by insurance companies. Instead, Elon Musk agreed with Tesla to personally provide coverage substantially equivalent to such a policy for a one-year period, and the other members of the Board are third-party beneficiaries thereof. The Board concluded that because such arrangement is governed by a binding agreement with Tesla as to which Mr. Musk does not have unilateral discretion to perform, and is intended to replace an ordinary course insurance policy, it would not impair the independent judgment of the other members of the Board.

If you are a director at a public company, you have a pretty high risk of being sued, personally, for stuff that the company does. At a big company a director's liability, for making decisions that shareholders and courts later second-guess, could be many millions of dollars. Directors do not want to pay out of their personal money for the company's troubles, so every company buys directors' and officers' insurance to defend and indemnify its directors against liability. No one would serve on a board without D&O insurance. 

If you are a director at Tesla you have, let's say, a higher risk of being sued than the average public-company director, because Tesla CEO Elon Musk likes to do weird whimsical stuff like pretend he's going to take Tesla private. This means that you really want D&O insurance, but it also tends to mean that your D&O insurance is expensive. Because Elon Musk loves to do weird stuff, Tesla has to pay "disproportionately high premiums" to insurance companies to defend its directors against lawsuits. 

It is inefficient. You could make it more efficient: Instead of an insurance company indemnifying the directors against Elon Musk's whimsy, you could have Elon Musk—a billionaire—indemnify them himself. So that is what Tesla is doing. It presumably saves Tesla money.

It might make the directors nervous: They have wrong-way risk, in that you could imagine Musk doing something so wild that both (1) the directors are sued for a lot of money and (2) he has no money anymore to protect them. But that's good! You want Tesla's board to be nervous! A company that has to pay "disproportionately high premiums" for D&O insurance should have disproportionately nervous directors. It gives the board an incentive to monitor Musk and make sure he doesn't do anything too egregious, since they're relying on him to pay for their defense if he does.[4]

Best of all, it might give Musk a reason to behave. If he does dumb stuff that gets his board in trouble, he will have to pay personally to get them out of trouble. If he keeps quiet and gets sued less than everyone expects, he—rather than an insurance company—will benefit financially from the improvement. I'm not sure he cares; Elon Musk is pretty clearly willing to spend millions of dollars of his own money to have fun joking around on Twitter. But if you are a public-company director you have to at least pretend to believe that financial incentives matter, and this gives Musk the right incentives.

Everything is seating charts

I have been saying that for years now, but I have always mean it in a sort of anthropological sense: Where you sit, physically, at work, does a lot to determine your status and sense of self-worth and general enjoyment of and commitment to your job. Corporate insurrections have started over who sat where in meetings.

Now, though, seating charts could be a matter of life and death. Here are Bloomberg's Jennifer Surane and Michelle Davis on how Wall Street banks are starting to think about returning to their offices, and the basic issue is how to keep employees away from each other:

Citigroup, Goldman Sachs Group Inc. and JPMorgan Chase & Co. are all trying to figure out how to reorganize their lobbies and elevators to prevent contagion. JPMorgan might station attendants outside elevators to help push buttons, so fewer workers need to touch keypads. Goldman is exploring ways to open doors without contact, possibly setting out towelettes that can be used to touch handles and then discarded on the other side.

More broadly, big banks are exploring taking an active role in monitoring the health of their employees -- checking temperatures on arrival, requiring masks be worn, possibly even at desks, and providing on-site virus testing to catch outbreaks quickly. Firms are planning to reorganize office seating and shared spaces like coffee stations and cafeterias. Some are debating whether to help staff commute without public transit. Even then, many older employees and those with medical conditions will likely have to work from home indefinitely for their safety.

One question is how these two considerations—seating as a public health matter and as a marker of status—will interact. (I mean, on trading floors and other open-plan offices. The classic status seat in many businesses is having a giant corner office to yourself; post-pandemic that will only be more attractive.) Sitting next to the boss used to be a high-status but high-stress situation; now the boss will not want to sit next to anyone. Sitting at the table—instead of on overflow seating against the wall—in a meeting used to mean that you mattered; now the table is potentially deadly. So many of the status markers relied on the importance of physical proximity, but now physical proximity is bad. And if you can't use seating to indicate status, why not just work from home?

Art Stuff

The last time MSCHF, a Brooklyn art/comedy/branding studio (!), were in Money Stuff, it was for a "proprietary financial astrology" app. They made an app that recommended stocks based on your star sign. It was a joke, of course—or an art project or a branding exercise—but, I thought, it made a nice point about investing advice. 

The latest MSCHF drop is even better:

The offbeat brand-cum-art collective known as MSCHF is cutting up a Damien Hirst work and putting it up for auction as an act of protest against investors who buy fractions of pricy artworks.

The Brooklyn-based artists and designers behind MSCHF purchased a $30,000 Damien Hirst spot print and cut out all 88 of its dots. Starting today, they're selling the dots for $480 each. Meanwhile, the original print, now just a piece of paper with 88 holes and Hirst's signature, is up for auction for a minimum of $126,500.

It is a commentary on the art market, fractional ownership of artworks, probably the blockchain. It is also an illustration of Jasper Johns's famous description of art: "Take an object, do something to it, do something else to it." Hirst's project hardly counts as art: He takes paper and prints colored spots on it. If he is doing anything interesting, it is to the fabric of late capitalism, not to the paper. MSCHF take the crucial artistic step of doing something else to the paper (cutting it up). Of course their print is worth more than his.

Also though it answers a really deep question, which is: Who is buying all these Damien Hirst prints? There are zillions of them—the one MSCHF cut up is from an edition of 55 prints of one painting, which is one of over 1,000 paintings in one of the 13 sub-series of Hirst's spot paintings—and one does not exactly see them in a lot of living rooms. What if, like all the subprime mortgages were once bought up by CDO-squareds, all the Hirst spot paintings are bought up by art securitizers and conceptual reshufflers and other repackagers? What if they are not art but merely contents for packaging, the raw material for future manipulations?

Things happen

Pandemic Triggers a Wave of Distress, Bankruptcy in Corporate America. Mortgage Chaos Threatens to Worsen Once It's Time for Repayments. Coronavirus Shutdown Weighs on Higher-Risk Muni Issuers. The Federal Reserve Is Changing What It Means to Be a Central Bank. Delta taps debt markets for $5bn to replace lost cash flows. 'Black Swan' funds enjoy rare chance to spread their wings. Former Delaware chief justice Leo Strine joins Wachtell. Luckin Coffee Under Investigation by China's Top Commerce Regulator. Antibribery Group Warns of Bribery Risks During Coronavirus Pandemic. CEO of Surveillance Firm Banjo Once Helped KKK Leader Shoot Up a Synagogue. Alleged Drug Dealer Arrested in the Tenderloin For Violating Shelter-in-Place Orders, Selling Drugs. "AB InBev and Constellation have also temporarily extended the expiration dates on their draft beers to buy the companies more time to deal with the glut of expiring beer." Kansas City Is Now Home to a BBQ Vending Machine. 'Oh no, I spelled it wrong': Nurse runs solo marathon in shape of 'Boston Strog.'

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[1] Given the speed with which prices dropped once they hit zero, you might conclude that the sellers were *very* price-insensitive. This could be because they were desperate to get out without having to take delivery, but it could also be because they weren't selling on their own behalf. If a broker had a futures client who didn't meet a margin call as futures prices dropped, and if the client had equity in other positions, the broker's incentive is to sell the client's May futures at whatever price it could get, even if that price was negative $37—the goal is to close the position, not to maximize equity.

[2] That's the ask price as of about 11:15a.m. Eastern today, against a futures price of around $11.90.

[3] Aaron Brown, by email, pointed me to this situation yesterday. Here's his math, based on yesterday's prices: "I notice the June 2020 WTI put at zero is trading for about $1.00, at the moment it's $0.98 bid / $1.02 ask, but open interest is only one contract. There is, however, significant open interest and volume at $0.50 and $1.00 puts. The ask prices are $1.07 and $1.12 respectively. If you ignore the chance that the price ends up between zero and $0.50, the $0.50 put is just like the zero-strike put, except that you get an extra $0.50 if the June price ends up negative. Since it sells for $0.05 more than the zero-strike put, the market is implying about a 10% chance of a negative oil price in June. The $1.00 put sells for $1.12, so the same 10% chance. These $0.05 increments continue up to $4.00 strikes, so the market implies zero probability (or less than 0.5% anyway) of a June price between $0 and $4.00, but all these options validate the 10% chance of a negative price. The $1.00 mid price for the zero-strike option, combined with the 10% implied probability of a negative price, suggests a conditional expectation of a negative $10 price if the price is negative. The calculation is confirmed by the call price, although that is forced by arbitrage. A zero-strike call option to buy oil in June costs $17.96 ask, while the futures price is $1.02 less, $16.94. So if you want oil for June delivery, but the option of walking away if the price is negative, you have to pay $17.96, more than the cost without the option to walk away."

[4] There is an argument that, because they are relying on him for this money, they will be more deferential to him. That's the argument that the board considered and rejected in that 10-K paragraph. It does not strike me as especially compelling; if I were relying on a whimsical billionaire's good behavior to protect my life savings I would supervise him more closely, not less.

 

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