Blown-Up Risk Models And Decimated US Drilling: Insane Week In Oil Leaves Trail Of Destruction

“There are only two things that can save the market from its current anguish”, an analyst at PVM Oil Associates told Bloomberg on Friday. “A recovery in demand or additional supply cuts”.

Suffice to say a recovery in demand is some ways out. Even as lockdowns are gradually lifted across the western world, it’s going to be quite a while before consumers are convinced the risk of getting sick is low enough to warrant engaging in the kind of “extra” economic and social activity that can rescue demand for fossil fuels from the largest shock in history.

Late in March, when it became apparent that crude was staring down its most challenging month ever, Goldman’s Jeff Currie delivered an incisive assessment. For those who missed it in “Goldman Says Oil Demand To Plunge 25% Near-Term In ‘Game-Changing’ Crisis“, here is the key quote from Currie:

With social distancing measures now impacting 92% of global GDP, the ultimate magnitude of these shut-ins which is still unknown will likely permanently alter the energy industry and its geopolitics, restrict demand as economic activity normalizes and shift the debate around climate change. Not only is this the largest economic shock of our lifetimes, but carbon-based industries like oil sit in the cross-hairs as they have historically served as the cornerstone of social interactions and globalization, the prevention of which are the main defense against the virus.

This month did, of course, end up being quite dramatic for crude. The IEA dubbed it “Black April” in their latest outlook.

It’s highly amusing to look back on the commentary from this past week, which, much like the week of February 5, 2018, found confused retail investors attempting to come to terms with the mechanics of markets they didn’t understand but decided to participate in nevertheless. In early 2018, it was VIX futures. In April, it was WTI futures.

You can relive the play-by-play in the oil archive, but I think my favorite quote from the entire week came from Pierre Andurand who, on Monday morning, warned “there is no limit to the downside to prices when inventories and pipelines are full”. His message was pretty clear if you were following along on Twitter in real-time. Essentially, Andurand said anyone not fully apprised of how the market works should exercise extreme caution. “Negative prices are possible”, he said.

Just hours later, May futures plunged deeply into negative territory. Henceforth, plotting the S&P with oil will no longer make sense.

Although it’s far too little, far too late, Aramco has begun implementing the kingdom’s commitment as part of the OPEC+ deal struck this month.

The state behemoth throttled back starting earlier this week and according to a source who spoke to Bloomberg, is “likely to be pumping at its targeted level slightly ahead of May 1”. The Saudis will reduce production to 8.5 million barrels per day under the deal.

Prince Abdulaziz bin Salman declared the alliance “up and alive” last weekend, only to see prices collapse in spectacular fashion the very next day.

Meanwhile, 45% of US oil rigs have been idled in the space of the last six weeks. It’s fair to say the US energy sector has never witnessed anything remotely close to the panic currently gripping the market. Uneconomic production is dead and buried. And this time, it’s unlikely that capital markets will be forgiving enough to allow the zombies to rise from the dirt.

In addition to the unprecedented six-week decline (shown in orange in the visual), the latest weekly decline (blue bars) was the biggest in percentage terms in 14 years.

Not surprisingly, this past week’s dramatics forced banks to recalibrate their risk models, which simply don’t work with negative inputs. Consider the following excerpt from an advisory notice issued by CME:

TO: Clearing Member Firms, Chief Financial Officers, Back Office Managers; FROM: CME; Clearing ADVISORY #: 20-171; SUBJECT: Switch to Bachelier Options Pricing Model; DATE: April 21st, 2020; Pursuant to Clearing Advisory 20-152 that was published on April 8th , the clearing house will switch the options pricing and valuation model to Bachelier to accommodate negative prices in the underlying futures and allow for listing of option contracts with negative strikes.

This isn’t the first time this has come up. It’s also a discussion in the rates space. So much for Black-Scholes.

This is particularly vexing in crude for a very simple reason: If you sell a put to a producer hedging against price declines and it becomes apparent that prices can go below zero, it theoretically means there is no limit to the losses you might incur.

As Bloomberg wrote this week, this could be especially cumbersome for banks participating in the famed “Hacienda hedge”. Mexico spends around $1 billion annually for the insurance against falling prices, but it paid off handsomely in 2009, 2015 and 2016, to the tune of $5.1 billion, $6.4 billion and $2.7 billion, respectively.

The sovereign hedge usually entails insuring some 250 million barrels via puts purchased from the likes of Goldman and even the trading operations of oil companies like Royal Dutch Shell. In addition to Goldman, Morgan Stanley, Barclays, JPMorgan, Deutsche, Citi, HSBC and BNP, have all been recruited over the years to participate in the massive deal, the most coveted oil trade on the street and, in some cases, an outsized portion of banks’ oil business.

One can only begin to speculate what the implications are for that program now that we’ve entered a brave new world for crude.

When things get particularly dicey, the mark-to-market on that Mexican monstrosity can be daunting — at one point in 2009, for example, banks reportedly owed the Mexican Treasury nearly $10 billion.

Banks’ efforts to keep their own positions squared in the face of massive hedging programs have been blamed for accelerating downside moves in crude on multiple occasions over the past several years.

When it comes to Mexico’s sovereign hedge, I would note that you can’t draw any definitive  conclusions based on one WTI contract trading negative for a couple of days.

Finally, bear in mind that all of this should be considered in the same discussion as last month’s historic VaR shock which exacerbated forced de-leveraging from major investor cohorts, amplifying the scope of cross-asset declines during March’s most tumultuous days.

A chart of oil volatility now looks similar to a chart of US jobless claims. That is: Historical precedent is no longer useful.

Now that’s what “shock and awe” looks like.

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