WTI futures market: Risk versus Return in an Unprecedented Era

The rollercoaster that is today’s West Texas Intermediate (WTI) futures market promises to give everyone connected to oil derivatives trading a very interesting ride in the weeks and months ahead.

Volatility in the oil market creates risks for market participants. Of course, it also creates the potential for large and rapid returns especially, as we are now seeing, as futures contracts approach expiry.

Indeed, the unusually volatile conditions may encourage more and more traders to start treating the WTI futures market like a monthly spin on the roulette wheel, taking bigger risks than normal in pursuit of bumper returns as every contract approaches expiry. It is a fact not lost on the US regulator, the Commodity Futures Trading Commission (CFTC), which is understood to have issued a rare warning in May that market participants should be particularly alert in monitoring and assessing risks in the current environment. 

But, alongside the obvious danger that some freewheeling traders could lose their shirts, high levels of speculation can introduce risks for others in the market, especially in over-the-counter (OTC) trades. Futures trades on regulated exchanges are arguably safer, since the effects of a bankruptcy or default by a member would be absorbed by the Exchange’s default fund, and spread across all members who contribute to it.

 

The evaporation of Liquidity

But, for OTC trade, when big price swings occur, exposures on existing derivative trades can change dramatically. In such a scenario, there is a risk that large participants reduce, withhold or withdraw credit facilities from smaller participants, potentially halting those participants’ ability to trade. This could lead to a loss of liquidity, creating additional risks that smaller participants cannot unwind positions which then quickly move “out-of-the-money”.

And, this scenario can unfold automatically. Reductions or withdrawals of credit limits are not necessarily the result of aggressive attitudes on the part of large oil traders. They can be triggered by credit terms in a trading contract, such as apparent breach of financial covenants or a perceived material adverse change (or “MAC” event). And, there is a risk that large traders, even inadvertently, pressurise small players with tougher terms, even to the point of effectively forcing them out of the market.

Furthermore, reports suggest that some oil futures brokers have now adopted a policy of exiting front-month futures positions several days prior to the contract’s expiry, in order to avoid the risk of being caught in a falling market with no chance of escape, other than to accept a big loss. This policy of course will reduce liquidity for all others in the days leading up to expiry and physical delivery, reinforcing the dangers outlined above.

And, it is not only WTI futures which present higher risks. Anyone trading the Brent/WTI spread will also have seen a big increase in potential returns. Therefore, some of the same risks will spill over into other derivatives markets where WTI is one of the “legs”.

 

Futures vs Physical

In the physical oil market, there is plenty which regulators and governments can do to manage and mitigate oil companies’ risks in the currently volatile conditions. Providing bailouts or subsidies, making fast-track approvals of mergers and takeovers, and in the longer-term, offering state assistance or support to ensure the orderly decommissioning of oil fields, wells and rigs, which may never come back into production again; all of these instruments are at regulators’ disposal.

But, the oil futures market is obviously different.

Tightened capital adequacy rules as some kind of source of added security would not work for many small, thinly-capitalised trading companies, and would force many of them out of the market. And, in any case, speculators, the bubbles on the stream of economic activity, are essential elements of free and liquid trade and of open and accessible energy markets. And, futures markets themselves cannot be suspended or halted, as they provide too much value as hedging mechanisms.

The CFTC’s warning is timely and logical. But it may also demonstrate a sense of anxiety and frustration, even of powerlessness, and a realisation that there is not much that regulators can do to mitigate the unusually high risks now evident in oil futures markets. In this context, the principles of self-regulation and adequate risk management for oil trading companies are as important today as ever.

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Published on 19 May 2020

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