Phil Verleger, Denver - Dec 10,2021

Open interest in oil future markets is dropping rapidly. The progression of events is not a new story. Futures markets for many commodities have grown, flourished and then died. Several forces are pushing oil futures toward what could be a terminal crisis. Open interest in crude and product contracts is tied to inventories, and a decline in stock levels is depressing open interest. A reduction in hedging by end-users such as airlines is further squeezing the market size, as is the abandonment of futures by independent producers such as Pioneer Natural Resources. Speculators attempting to enter the smaller market will serve mainly to boost price volatility — and will soon learn that oil futures have become a losing proposition due to the lack of industry participation.

Are oil futures markets dying? At the end of the first week of December, open interest in Brent, gasoline, distillate and gasoil futures was all way below levels in prior years. Open interest in gasoil traded on ICE was down 27% from the same date in 2020. Open interest in New York Harbor distillate was down 19%, and open interest in gasoline was down 26% year on year.

Open interest in the major crude oil contracts was off as well, although by smaller percentages: Brent declined 10% and the CME West Texas Intermediate (WTI) contract by a mere 7%. Open interest in the various contracts was also down compared to early December in 2018 and 2019.

The drop in open interest is a concern because, as those who write on futures markets have pointed out, contracts effectively become gambling instruments without sufficient commercial participation.

The head of United Airlines offered one explanation for the shift a few weeks ago. If one googles the phrase “United Airlines does not hedge fuel,” the following item pops up without a URL, presumably because it is available only behind a paywall: “We don’t hedge fuel, because the cost of hedging is so expensive," United CEO Scott Kirby said, via a recorded video interview.

Distillate and gasoil have suffered a one-two punch. The loss of hedging by weakened airlines is a blow, because airlines were one of the most crucial end-users of futures before the Covid‑19 crisis. Distillate and gasoil futures and forward markets also lost because distillate and jet fuel consumption remains depressed, due to the same drop in air travel that has walloped airlines.

Physical Flaws

There may be two more fundamental threats to most futures markets: the reliability of the underlying physical commodity and increased market concentration.

BP highlighted the first of these threats in a recent comment to Platts, regarding changes in the dated Brent contract. BP said that the current contract for physical delivery, created by Royal Dutch Shell years ago when production volumes of Brent and nearby crude grades was much higher, is “no longer fit for purpose.” BP proposes revisions to bring WTI shipped to Europe from Corpus Christi into the pool for potential delivery under the contract. Other firms, commenting on proposals published by Platts, have backed WTI shipped from any US port.

The difficulty in defining an appropriate physical counterpart for the Brent futures contract undermines its credibility. Thus, it should be no surprise that commercial use of the Brent contract has declined. In contrast, commercial use of the WTI contract, which precisely specifies the deliverable commodity, remains relatively unchanged.

Increased market concentration among those who buy and sell crude and petroleum products may help explain the drop in open interest, as well, especially in product markets. Futures were introduced almost 50 years ago when multinational companies abandoned marketing, particularly in the northeastern US. The abandonment threatened to leave many heating oil dealers with no way to finance the inventories they needed to accumulate ahead of winter. The heating oil futures contract, implemented by Nymex, solved the problem. Commodity brokers breached the wall the oil industry had built to keep traders out of the business.

Nymex and later the IPE built on the success of the heating oil contract, enabling smaller product dealers and producers to expand despite price volatility. Financial institutions welcomed the development and required their smaller clients to hedge as a condition of loans.

The situation is different today. The market capitalization of one retailer, Alimentation Couche-Tard, is almost as large as ConocoPhillips. The rise in concentration has led to higher retail margins and retailers’ ability to negotiate aggressively with refiner suppliers. Also, most refiners are now much better capitalized than their counterparts were 40 years ago. Further, the visibility of prices to all market participants has improved, and futures contracts, consequently, have become an expensive and unnecessary luxury.

At the same time, independent oil producers, flush with cash from the recent price rise and imbued by a new discipline to pay shareholders rather than drill, are cutting back on hedging, too. Companies such as Pioneer that were large — and not very adept — hedgers have stopped hedging, after needlessly sacrificing billions to their financial counterparts. Pioneer incurred billions in losses because the company chose to hedge without putting up cash. It did this by selling call options, giving up the upside to buy puts. In contrast, Mexico has followed a relatively low-cost and very successful hedge program for 30 years, paying in advance every year in order to keep the profits.

Inventory declines have further cut into the need to hedge. Recent decreases in open interest for crude and products are closely tied to the drop in inventories.

Volatility Ahead

The diminished size of industry participation in futures markets will make such markets more volatile due to their bilateral nature. Those encouraged to buy by the investment banks find that few parties are willing to sell. Prices will be pushed higher and higher on less and less volume. When prices start to decline, as they inevitably will, those who bought will find they cannot get out because there are no buyers.

Ultimately, oil futures and forward markets will shrink to the point of insignificance. Again, those who have followed commodity markets understand this. It is not a new story.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC.

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