Futures are Hard – Hurricane Edition

Who doesn’t love a good hurricane. The slow moving train wrecks rotating on our screens draw people like moths to a flame, or as our own Jeff Malec put it:

Thank goodness for modern science and satellites and Jim Cantore who can properly warn anyone with a cell phone (i.e. – everyone) when it’s worth paying attention to, when its time to evacuate, and so forth. We may all secretly and perversely like seeing the raw power of nature, but surely nobody wants anyone to get hurt.

Which brings us to a different kind of hurt – market movements with hurricanes. While a lot of us were left scratching our heads on how futures markets could see crude oil go negative back in March, hurricanes give a great example of how futures markets work with different delivery dates (and places). Hurricane Katrina and the mess it made of New Orleans has long been the classic example of this, and with Hurricane Laura bearing down on around 20% to 40% of US refinery capacity, this seems like a good time to review how this all works.

You start with raw (or Crude) Oil, much of it pumped from Texas or from offshore rigs in the Gulf Coast area, and you put it into a refinery to process it into usable gasoline and other distillates, in a process they call “cracking”, thus the term the crack spread, which is the Crude Oil vs its offspring, gasoline. The gulf coast typically runs at about 95% capacity rates, meaning it uses nearly all of its capacity for refining Crude Oil into gasoline (and other oils used to make everything from tires to plastics and all sorts of other things).

Enter a nasty hurricane that could bring 10 feet of storm surge and blow pieces of your refinery a few miles away. What to you do? You shut down the refineries until the storm passes, to protect the equipment and keep the people safe. No refining means less gas supply, means higher prices per simple supply/demand economics. Now, if that’s for a few hours, or even a few days… no big deal, the refining will be back on line shortly and all that happens is a few gas stations may have their new gas shipments delayed a few days and prices may go up slightly.

But if it is a major catastrophe on the scale of Hurricane Katrina, and refineries are knocked out for weeks, you get a very different scenario. There’s plenty of oil, you just can’t refine it. You can’t get in there to turn the machines back on, which causes a unique environment where the front month futures contract spike dramatically, because all the gasoline available for that delivery will be used up (they won’t be able to refine more of it), while the further out (potentially even the very next month) contract will fall, because once that plant turns back on, the gasoline trapped in there plus new gasoline will start flowing. That’s not economic demand, it’s not about finding a new oil well and supply. It’s not about the raw oil you’re refining becoming more expensive. Not, it’s almost entirely about just a timing issue – where you can’t refine the oil til next week or next month, and that date falling outside of the futures expiration. Here’s what those spikes look like when normalizing the gas price to the price of oil to remove spikes due to oil spikes.

All that is to say futures are tricky. As we found out with the negative oil price earlier this year. The expiration dates matter. Whether you can store (in that case) or get access to (in hurricane cases) oil or gas by the delivery date can become the main driver of prices in certain extreme examples. When trading USO or similar products which use futures to track commodity prices, we sometimes forget that actual behind the scenes mechanics. Hurricanes and pandemics can remind us quickly that those small details matter.

One last note on so called delta neutral trading strategies such as trading the crack spread or trading a calendar spread in Gasoline where you may be short Sep. futures and long Oct futures. Such strategies can be sneakily seductive, making one believe there is less risk because the overall market moving up or down won’t hurt your position (being long and short at same time). It is only a change in their relative standing which will cause profits or losses. Don’t be fooled. These strategies can blow you out faster than you can say Amaranth if the dynamics between months or products shift because of something like…. a hurricane.

Stay safe, everyone.

More reading = our past hurricane related posts here.