CME CME Group Inc

By Alexander Osipovich 

Negative oil prices threaten to tarnish the image of West Texas Intermediate, the U.S. crude benchmark, and hurt the company that has long relied on it as a key source of revenue: exchange giant CME Group Inc.

Chicago-based CME is home to the WTI futures contract, which is a popular way for oil drillers to protect themselves against price drops or for hedge funds to speculate on the direction of energy markets.

Futures are contracts that let traders bet on the future price of commodities like oil and gold, or on financial indexes like the S&P 500. Unlike stocks, futures can sometimes drop below zero, particularly in physical commodity markets when storage facilities fill up and producers pay to get rid of their excess inventories.

Negative prices have occurred in futures on natural gas, electricity and some obscure regional grades of crude oil, but until this week they had never happened in a flagship oil contract like WTI. On Monday, WTI futures for May delivery slid to minus $37.63. They later rebounded to $10.01 Tuesday when the May contract expired.

CME had just changed its computer systems earlier this month to allow negative pricing in WTI, anticipating such a scenario, and many traders had discussed it as a possibility. But for many casual investors, the move was puzzling and appeared to be the latest sign of market mayhem unleashed by Covid-19.

CME Chairman and Chief Executive Terrence Duffy said in an interview that WTI futures worked as designed, and their foray into negative territory was a signal of real market forces at work.

"It's not a price that makes you feel good," he said. "But the reality is, there is oversupply, there is under-demand that's virus-driven, and there is nowhere to put the stuff."

While CME doesn't specify how much money it makes from individual contracts, UBS analysts estimate that about 14% of its revenue this year will come from energy, which includes oil, natural gas and other contracts. Last year CME posted $4.9 billion in total revenue.

CME's WTI franchise could also be hurt if investors sour on oil-focused exchange-traded funds. This week's price plunge caused hefty losses for investors in ETFs like the United States Oil Fund, a popular vehicle for betting on oil prices. Known by its ticker USO, the fund holds WTI futures and sometimes accounts for a significant chunk of activity in the contract, lifting CME's fee revenue.

Last week, USO held more than a quarter of outstanding contracts for June WTI futures, following massive inflows from investors. USO's operator, United States Commodity Funds LLC, said Tuesday that it issued all its registered shares, an unusual event that effectively turns USO into a closed-end fund and could lead to further deviations between USO and oil prices.

If WTI futures turn negative again, such deviations could continue, for the simple reason that an ETF--as a security--can't trade at prices below zero.

"If the ETF is tied to the futures and the futures go negative while the ETF can't, there will be dislocations," Mr. Duffy said. "People should know that before they invest in these instruments."

Speaking Tuesday afternoon, Mr. Duffy said the WTI expiration had gone smoothly and CME didn't anticipate any defaults by its clearing firms, the futures brokerages that act as intermediaries between traders and the exchange.

Still, it is possible those brokerages' clients, such as oil-trading firms, suffered big losses. In futures markets, when contracts are settled, the exchange and its clearing firms move money from traders with losing bets to traders with winning bets. If a losing trader can't pay up, the trader's clearing firm must eat the loss. In extreme cases, client losses can push a clearing firm into default, which can force other clearing firms to cover its losses.

That doesn't appear to have happened in the oil market this week. Still, some fallout from the wild price moves emerged Tuesday as Interactive Brokers Group Inc., an online brokerage popular with day traders, reported a provisionary loss of $88 million due to several clients that blew up because of Monday's collapse in WTI prices.

After WTI's foray into negative territory, some analysts suggested trading volumes could migrate from WTI to its main competitor: the Brent futures contract listed on CME's archrival, Atlanta-based Intercontinental Exchange Inc., or ICE for short.

"While both products will likely see ramped up volumes because of crude oil's volatility, we believe Brent, because of its stability, could gain traction as a stronger benchmark," Piper Sandler analysts wrote in a Tuesday research note.

CME and ICE have long bickered over which is the better barometer of the energy market. At stake in the fight are millions of contracts that change hands each day and the fee revenue that brings to both exchange operators. Much of that trading is by investors who want energy in their portfolios and are indifferent to the arcane details of the WTI and Brent contracts, including individuals who invest in ETFs linked to oil prices.

WTI futures are tied to the price of oil delivered each month to the storage hub of Cushing, Okla. Meanwhile, Brent futures track the price of seaborne crude, relying on an index calculated by ICE. Even though the two benchmarks have their respective home turf--WTI is U.S.-focused while Brent is more relevant elsewhere--they tend to move in tandem.

CME has long argued that WTI is the better benchmark because of its tighter link to the physical oil market. But its link to the world of drillers, refiners and shippers of physical crude oil was also behind this week's plunge into negative prices.

"What's usually the virtue of the WTI contract, its physical settlement, has actually turned out to be a drawback," said Craig Pirrong, a finance professor at the University of Houston. "It demonstrated that there are circumstances when physical settlement doesn't work well. Granted, these are exceptional circumstances."

Against the backdrop of the coronavirus pandemic, which has sharply reduced energy demand, excess oil supplies flooding into Cushing led storage there to fill up this month. The approaching expiration of the May WTI futures forced buyers of the contracts to either take delivery of oil or exit their trades by selling.

With storage hard to find, many sold the futures and found few others willing to buy them, causing Monday's record drop into subzero prices. ICE's front-month Brent futures also fell sharply that day, but settled at the more comprehensible price of $25.57 a barrel.

Write to Alexander Osipovich at alexander.osipovich@dowjones.com

(END) Dow Jones Newswires

April 22, 2020 05:44 ET (09:44 GMT)

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