Nick Bayley and Florian Nitschke say last month's crash in the price of West Texas Intermediate (WTI) represents a bad omen for the post-pandemic marketplace.
Last month, the price of West Texas Intermediate (WTI)—the U.S. oil benchmark—turned negative for the first time in its history as investors effectively paid other market participants to be able to trade out of their oil futures positions. The crash and ensuing market rout caused some participants, including retail investors in oil funds to sustain substantial losses.
The sudden collapse of the WTI price to a low of -$40.32 on 20 April owed much to a technical dislocation in the U.S. oil market. Concerns about a lack of capacity at the central storage facility in Cushing, Oklahoma, and failure by investors to roll over their May contracts to the following month, had many scrambling to sell their exposures before they had to take delivery of the product.
The lack of real "issuers" of the financial instruments and the fact that various pieces of non-public information are owned by numerous market participants, means there is no single mechanism for ensuring on-going symmetry of information. In the case of oil storage capacity, each participant will likely hold a piece of the puzzle."
It also reflected the intense volatility engulfing the global oil market in recent months: on one hand, the sharp decline in international demand resulting from the economic impact of measures to contain the covid-19 outbreak; on the other, the brief but intense price war involving Russia and Saudi Arabia following a row over production cuts.
Regardless of the underlying causes, the severity of the crash and the impact on investors raises questions about the availability and timing of market-moving information in this somewhat opaque sector and whether non-professional investors should be participating in the oil market in the first place.
Asymmetry of Information
Public capital markets function on the premise that all market participants receive the same price sensitive information at the same time. Quarterly results and trading updates are released to the stock exchange so that no investor has an advantage. Any inside information must be published by companies—the issuers of the shares—without delay, and failure to do so can result in sanctions for directors.
The absence of an effective mechanism to achieve the symmetry of information and ensure rapid price discovery will undermine confidence in a market and make it harder for it to operate efficiently.
There are typically two ways of ensuring the symmetry of information. Firstly, by requiring that holders of certain key information must make this public in a fair and expedient manner. Secondly, by having a central mechanism which collects and publishes such information. Both concepts are in use in the oil markets but are incomplete.
The EU definition of inside information in commodities markets, including oil, is similar to that for the equity markets but with the additional requirement that the information is "reasonably expected to be disclosed or is required to be disclosed." However, the lack of real "issuers" of the financial instruments and the fact that various pieces of non-public information are owned by numerous market participants, means there is no single mechanism for ensuring on-going symmetry of information. In the case of oil storage capacity, each participant will likely hold a piece of the puzzle.
Most traders know about their own immediate capacity and constraints, but some will know relatively little about those of the market as a whole. At the same time, a number of large international groups who are active all along the value chain (production, shipping, refining) will gain a larger picture of market activity which allows them to gain a deeper understanding.
Individual participants are also not expected to make price sensitive information public. Note that this is different from the EU energy markets where Article 4 of Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) stipulates that "information relevant to the capacity and […] storage" must be disclosed in an effective and timely manner.
In the absence of well-defined and enforced requirements to publish inside information in oil markets, public bodies such as the U.S. Energy Information Administration (EIA) have sought to take on the role of a central mechanism by publishing official figures. While these provide useful data, they are only published weekly and so lag actual capacity. To get a legitimate edge, some market participants resort to other means, such as flying drones over storage tanks to gauge capacity levels.
Lessons from Soft Commodities
Market practice for other commodities has evolved differently. Investors in soft commodities like coffee and cacao, as well as metals, benefit from daily information on storage capacity at approved warehouses, published on the London Metal Exchange (LME) and the Intercontinental Exchange (ICE).
The creation of a more transparent oil market is fraught with challenges. Oil will remain a commodity whose supply is controlled by a mix of commercial and state actors with their own particular priorities. Requiring sovereign countries to provide the oil markets with reliable, up-to-date information on production and shipment is unlikely to work.
Yet, asymmetry of information does not have to be an unalterable fact. Other commodities markets provide a blueprint for how oil can be more transparent, and ultimately fairer for investors. However, until such time as some form of centralised reporting mechanism exists and daily reporting is required, non-specialist investors need to take care and be aware of the risks of an unlevel playing field.
Nick Bayley is managing director, and Florian Nitschke is a director, at Duff & Phelps' Compliance and Regulatory Consulting practice