What future for fossil fuel futures?
The turmoil in oil derivatives markets could be a catalyst for change
Financial derivatives have a way of behaving larger than life. Like funhouse mirrors, they don’t always accurately reflect the assets they reference. But unlike these carnival props, the distortions they produce can be transmitted back into reality, with very real consequences.
Oil futures plummeted last week, with the front-month West Texas Intermediate (WTI) May contract plunging to negative $37.63 on April 20, a first for the market. The bizarre price action was a function of lopsided demand, as financial traders — not wanting, or able, to take physical delivery of the oil — fled the market, forcing sellers to pay others to take it off their hands.
As Matt Levine of Bloomberg observed:
Events in the real world caused this — the real actual lack of current demand for oil was the basic problem — but oddities of financial markets exacerbated it; what made the price negative thirty-seven dollars was less “drillers have produced too much oil and are rushing to get rid of it” and more “financial speculators have purchased too much virtual oil and are rushing not to actually get it.”
The episode spotlights how the financialisation of commodities allows exposures tied to them to build up out of control, and among entities completely separated from the business of acquiring or processing them.
Take the WTI futures traded at CME Group. Data from the Commodity Futures Trading Commission (CFTC) shows that open interest — the number of outstanding contracts — stood at 2,276,638 on April 21. Each contract is for 1,000 barrels.
Oil producers, processors and users accounted for 21% of these contracts, but hedge funds, commodity trading advisors and other money managers made up 32%. Credit intermediaries and non-bank traders made up the remainder. A large chunk of WTI futures exposure is therefore held by financial institutions with no interest in actually owning, refining, or selling physical oil.
Source: Commodity Futures Trading Commission
Futures offer these traders access to leverage, enabling them to make huge bets on the price of oil for just a sliver of the actual value of each barrel, an amount known as margin. But it also means they are exposed to huge losses if the market turns against them.
Last week, a host of speculators were wiped out when prices turned negative. Interactive Brokers, a major retail securities firm, disclosed that some of its clients lost big on the May settling contracts, incurring losses that exceeded the value in their margin accounts. This put Interactive Brokers itself on the hook for $88 million. Bloomberg reports that some 3,700 retail investors in Bank of China’s Crude Oil Treasure fund — a product linked to the WTI contract — collectively lost $85 million.
Losses like these should serve as a wake-up call. Speculators have exposure to billions of dollars’ worth of derivatives linked to oil, with banks and clearing houses acting as intermediaries — firms essential to the smooth running of the financial system. Wild price swings are likely in the short-term, as the world grapples with the coronavirus-inspired recession, and in the long-term as it lumbers towards a net-zero carbon future.
Time for margins to toughen up
Reining in speculators’ exposure to oil contracts should therefore be a priority of policymakers and climate risk managers alike. One quick fix would be to hike margin requirements for oil contracts. This would raise the barrier to entry, deterring retail investors and thinly-capitalised funds from leveraging their positions to dangerous levels.
Exchanges usually set the initial margin — the amount needed to open a futures position — at around 3-12% of the notional value of the contract. It’s typically higher for the WTI futures traded at CME Group; historical data shows the initial margin for the front-month contract from March 2 to March 19 ranged between 7-22%. But the margin for other contracts is even greater. For example, initial margin for CME bitcoin futures was set at 35% of notional value at inception.
Upping margin requirements for fossil fuel derivatives is a policy recommendation floated by Graham Steele, director of the Corporations and Society Initiative at Stanford University, in his paper “Confronting the “Climate Lehman Moment”: the case for macroprudential climate regulation”:
“Stringent margin requirements should be imposed on transactions that involve securities and derivatives tied to, at a minimum, the big 100 corporate emitters, deforestation-related agribusinesses, and fossil fuels and other climate-damaging commodities. Ideally, they would apply to both the calculation of credit exposures of such transactions as well as the haircuts applied to collateral. Such rules would help to reduce the likelihood, and the cost, of a “climate Minsky moment” hitting financial markets, and likely apply to more transactions that one might initially expect.”
A popular complaint against high margin requirements is that they make it more expensive for end-users to hedge their exposures. Pricey margins could also deter speculators, draining liquidity from the futures market. If oil producers and processors are unable to guard against price volatility, the argument goes, they could suffer catastrophic losses when physical oil prices plunge — leading to bankruptcies and disorderly collapses.
But hedging is one of the costs of doing business. If oil prices are highly volatile, the price to eliminate this market risk should also be high. Besides, energy firms’ profit margins should not depend on rock-bottom futures margins.
Also, perhaps some speculators need to be sent packing from the market. Interactive Brokers must feel this way about the clients who just cost it $88 million.
In addition, hiking margin requirements would also ensure that central counterparties (CCPs) and the clearing banks that handle futures trades have enough of a buffer to protect themselves from losses. As of end-December, US banks had about $1.2 trillion of commodity derivatives exposure in contract notional.
The nightmare scenario is a clutch of major dealers and CCPs all having to use their own equity to make good losses their clients fail to cover in a prolonged oil price rout, which drains their capital reserves and makes them less capable of withstanding further crises. That’s how an oil crisis could precipitate a financial crisis.
There’s a wider point to be made here, too. The popularity of oil-linked derivatives has made the success of the fossil fuel industry something that’s in the best interests of financial institutions. Brokers would struggle to market WTI products to retail investors if crude was not such an essential commodity. Hedge funds would be unable to profit from betting against oil producers and users in the futures market if they all suddenly shut up shop.
Making oil derivatives expensive and tough — if not impossible — for retail investors to trade could therefore also help undermine the vested interest the financial sector has in black gold.
If fossil fuel derivatives can be made unattractive, is it also possible to make products linked to combating climate change popular? “Green” is all the rage in traditional bond and equity markets, so could it make a splash in derivatives markets, too?
Intercontinental Exchange (ICE), a leading exchange operator, is giving it a go. On April 22 it launched a Global Carbon Futures Index, based on prices traded in the most active carbon futures markets. Carbon futures are contracts based on the value of CO2 emissions as determined by regional cap-and-trade schemes.
ICE hopes the new index will provide an “accurate, transparent global price for carbon”, one that policymakers could use to set binding carbon tax levels for corporations, or financial institutions use to charge fossil fuel-guzzling clients.
The index could also act as a building block for new financial products. Enterprising firms could build funds or structured notes linked to the index, allowing ESG-minded investors to bet on the price of carbon. This in turn would create a deep and liquid market that carbon end-users could then tap to hedge their financial exposure to a net-zero transition.
Plenty of hurdles lie ahead. First, the emissions market is geographically fragmented, with each region having a separate carbon price and the cap-and-trade schemes they encompass covering different sectors. Then again, the oil market is similarly splintered.
Second, and more importantly, demand for oil is universal whereas that for emissions credits is factional. Appetite for emissions futures only exists in those jurisdictions where binding cap-and-trade agreements are in place — chiefly the European Union and 11 out of 50 US states. Without blockbuster demand, it’s hard to get financial institutions to shovel money into new products.
This could change overnight, however, if more governments mandated cap-and-trade programs. Financial markets may provide distorted reflections of the underlying economy, but they are still that — reflections. Without the political will to create far-reaching emissions markets, derivatives for hedging and speculating on these will struggle to take flight.
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