The Ultimate Short Squeeze

As you can imagine, a lot of people involved in the financial markets these days are very edgy.  Millions of pairs of eyes are focused on news headlines, the S&P future contracts, value of the USD and, you guessed it, oil.  Oil here in the US trades via monthly futures contract by the most part.  Just like other futures contracts, you have to roll your contract when it nears expiration to maintain your exposure.  There is, however, something a little different about oil and other commodity contracts: if you don’t roll the contract at expiration you’re going to get the underlying commodity delivered to you.  This resulted in a very interesting chain of events yesterday…

The crude contract for October delivery had its last day of trading yesterday.  The days prior to the last day of trading the roll had appeared to some as being been expensive (see the historical spread between the October delivery and November delivery contracts to the right).  So it seemed a lot of market participants decided to wait it out.  Bad move!  The roll on the last day of trading for October delivery (yesterday) got as expensive as $11 at one point during the day, jacking up the price of the front contract more that $25 in a single day, the most since oil started trading via futures since back in the 1980s (I think).  Due to the fact that people left holding the front contract at the end of the day yesterday would have had oil arriving on their doorstep, anyone who was short was basically forced to buy back the contracts at massively inflated prices, resulting in the huge price spikes seen in the front month.  The two plots below show the price action of October delivery (left) and November delivery (right) during the day.  No big price spike in November delivery, because no short squeeze…

You might find yourself thinking, why didn’t arbitrageurs just step in and sell the crude back down to its fair value?  Well, that’s where the delivery aspect comes in: inventory supplies at the moment for October delivery are extremely tight, the oil futures contracts are deliverable in Oklahoma, and to get to Oklahoma you have to ship crude in through Texas.  What’s been going on in Texas recently?  Hurricanes.  One report I heard yesterday alleged that there were over 200 tankers queued up to offload their oil into the Texas pipelines.  So all those speculators wanting to get out of their October delivery contracts and into November ones couldn’t find anyone to sell them deliverable contracts, because the underlying oil just wasn’t available.  I asked one broker what happens if you let your contract expire but can’t take delivery of your oil.  His words: “you end up with an expired futures contract and whomever buys it off you will rip your face off with the price!”

And finally, to make matters worse, there were a lot of $115 strike options out there.  Market makers walking in to work yesterday morning and seeing the price at $105 were probably feeling pretty comfortably hedged (with zero delta).  But as the short squeeze ensued they would have had to start hedging like crazy as the price broke their strike, only further exasperating short speculators.

I don’t know if I’d personally go this far, but I heard it shouted across the desk yesterday that this is a good example of the fact that speculators can’t manipulate the long-term price of commodities.

The perfect deliverable futures storm.