I am not an expert on futures but I believe I have a strong understanding of how they are settled. If I am missing something, please correct me.
Physically settled futures are an agreement to buy/sell x barrels of oil at y price on such and such date. Let's say the settlement date is April 20th. On the 20th anyone on the buy side of a physically traded future must actually buy and receive x barrels of oil at y price. Anyone on the sell side must physically obtain and sell x barrels of oil at y price. If you agree to sell x barrels of oil at $92 but a barrel of oil actually costs $140 you are going to take an enormous loss. Either you already own the barrels of oil and are selling them for $92 instead of $140 like you could on the open market, or you don't have any oil, need to buy it on the open market for $140 and then sell it for $92. Either way you are taking a loss of about $50 per barrel. The physical future price on the settlement date should equal almost exactly the spot price since people do not want to lose money.
Futures that are settled in cash are settled at the value of the physical futures, which should ensure the settlement price matches the spot price on the day of settlement. The only way this would not be the case is if someone is willing to lose massive amounts of money manipulating the physically settled futures to be different than the spot price. Even then it seems impossible to do this to any meaningful amount since there should be plenty of traders taking advantage of this.
Posted by Nerdslayer2
6 Comments
You can also roll the contract over into the next window. Not really sure how that works, but I assume that would be up to the buyer and not the seller. Not sure why the buyer would do that given the spot price gap unless the buyer and seller are the same entity/the ones manipulating the market.
If anyone could ELI5 the rollover process, that’d be helpful because I don’t really understand the pros/cons and when it makes sense/who makes the call to roll over.
It’s incredible hard to understand the current disconnect between the futures price and the physical price. I fully acknowledge the two don’t need to be exactly 1:1 but the gap between SHOULD in any “normal” market environment, be rapidly converging as the May WTI contract is about to start rolling over. I truly consider myself a very levelheaded, rational person, even highly skeptical person but I keep coming to the same conclusion to explain the current market movements:
Only one market participant is big enough to basically subsidize everyone buying WTI futures and that’s the US Treasury Department, they have an almost unlimited ability to short the futures but they can’t participate in the physical market, hence why the massive gap has persisted. Eventually the Treasury Department will have to crystalize massive losses due to it’s inability to force physical prices lower but I guess this has been deemed to be a cost of the Iran war.
Even for the US Treasury Department, I view this as a very temporary strategy as the losses of subsidizing every WTI futures trader, very rapidly grow unimaginably large.
Please tell me why I’m obviously a braindead conspiracy-uncle, I really really want there to be a more “normal” explanation but my head just can’t seem to find it.
Im guessing that the market knows most futures trader can’t take physical delivery to profit from the disconnect. So it’s priced in?
But who knows, I’m just another regarded Redditor
>If you agree to sell x barrels of oil at $92 but a barrel of oil actually costs $140 you are going to take an enormous loss.
A mark to market loss. You are still exchanging physical oil for $92 a barrel at Cushing for May delivery. And judging by the numbers you’re using, no, if May settles at $92 you don’t all of a sudden lose $48/bbl. This $140 that keeps getting used is for Brent in the North Sea and it was probably for April 20-24 loading window or something. Entirely different things
A cash settled contract is a cash settled contract. There is no physical exchange of the commodity. Going with May WTI again (which is physically settled but let’s assume it’s cash settled). It stops trading on what the 21st of April? For simplicity just assume the price it stops trading on, on the 21st, is the final price of the contract. Ignore any of this physical spot price that keeps getting referenced. The price at the end of the 21st is the price of a futures contract. You’re entering into a contract for a specific price at a specific point in the future.
Here’s a paper from an actual expert on this topic.
[https://www.oxfordenergy.org/publications/energy-quantamentals-the-oil-crisis-in-the-eyes-of-a-financial-trader/](https://www.oxfordenergy.org/publications/energy-quantamentals-the-oil-crisis-in-the-eyes-of-a-financial-trader/)
One thing to keep in mind is that, while traditionally traders profit off arbitrage through physical settlement of futures, ie by buying x amount of barrels at spot and then selling a futures contract then maximising the storage efficiency and pocketing the difference, this market is actually dwarved by the pure paper trade, where traders will enter a synthetic position WITHOUT buying physical oil. They short the front month and long the back month. When front month futures spiked because of the war, these traders began looking at massive losses. For this reason there is a huge vested interest in keeping the futures curve as flat as possible in order to minimize their losses.
Given the current oil shortage, they won’t be able to secure supply for delivery to meet their obligations when the market expires. This will trigger the price convergence for WTI
For Brent the mechanism is different, it does not require physical delivery so there is no hard deadline for when shit hits the fan. The Brent futures are based on physical North Sea trade prices. Right now it does seem like Brent is being artificially suppressed relative to spot. However this is unsustainable in a true physical shortage. When end users realise that futures are no longer a guarantor of real oil supply, they will exit the paper market. The paper market will eventually have to self correct to preserve its legitimacy, otherwise it will break fundamentally and no one will use it