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  • Lord Copper

Oil in troubled waters


Trading Exchanges don’t always get things right. We’ve written on here for the past four or five weeks a succession of articles which have nor been particularly complimentary about the LME’s recent handling of the nickel market. I’m going to give that one a break for this week and look at the apparent re-emergence – in the US courts, where else – of a previous story of an Exchange.

Cast your mind back, if you will, to April 2020. Lockdown, Covid-drenched atmosphere, eerily empty city streets, economic slowdown and a collapsing oil price. Doom, gloom and misery all around us. Well, for most of us, but not for  small group of independent (ex-IPE, mostly) oil futures traders in suburban Essex. They – twelve or so of them – had a good day, one day in that benighted April; they made a profit in a day’s trading of something in the order (reportedly) of $600-700 million; well, we’ve all had good days, but I have to confess mine were never that good.

Now, I’m not an oil trader, but I think I have a reasonable understanding of how commodity markets work, what makes the prices go up and down and the relationship between supply/demand and price. By April 2020, one of the effects of the lockdowns across myriad countries was to decimate industrial production and thus cause oil demand to fall off a cliff; because shutting the supply side is not a quick and easy operation, stocks of oil in tanks and tankers worldwide was increasing sharply. Add to that the particular delivery issues of the WTI contract – which is principally what our Essex men were trading – and it was pretty obvious that the price was heading sharply downwards. Indeed, I can well recall boring anyone who would listen by telling them that the oil price had a very strong chance of getting close to zero because of oversupply and storage problems; admittedly, I didn’t really think about the negative prices we actually saw.

This is where the story gets interesting, because one of the features of the Nymex WTI contract is that there is a facility to ‘trade at settlement’; this means that you can enter an order to buy or sell at the settlement price of the day – not that you have to try and achieve that price by trading, as would be the case in the LME’s open outcry system, but that you are guaranteed. So, if you take circumstances into account, when it was frankly blatantly obvious that the price was going down, then it’s not a huge leap to reach the point where you can see that the risk of shorting the market and balancing those sales with trade at settlement purchases gives a far more attractive risk profile to the trade than a simple short with the need to be able to make covering purchases in the open market. It doesn’t remove the risk, but it sharply reduces it.

By making that trading opportunity, the executive of the market created exactly the potential for the market aberration which is now the subject of legal action. I have to come back to the LME and nickel: what we see in both cases is market owners or managers actively creating problems, rather than being the passive forum in which trading can take place amongst well-financed members, which was the original function of commodity exchanges.

The legal action in the Nymex case is not focussed on that issue. It is a claim by a market participant who lost money that the traders in question were operating as a concert party, to some degree or another. Obviously, I have no idea of the veracity of that claim or the defence against it; but the Exchange bears some guilt in the way it enabled such trades to happen. We see it again; exchanges need to focus on the legitimate business they were set up to facilitate, not to tweak rules or contract specifications constantly to appeal to ever more HFT/algo trading volume. We need to remember what is important here and it’s not constant chasing of volume for it’s own sake, often at the expense of the underlying business, which matters to all of us. Commodity trading is a crucial part of our global economies; it’s not just a game to attract more and more volume – the effects of rule changes and tweaks need far more thought.

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