Oils Ain’t Oils

Oil prices are literally through the floor and it’s making crypto look like an oasis of stability.

On April 20 you could, for a brief moment, get paid US$40 for buying a barrel of oil. For a sense of how insane that is, try and imagine it happening to any other commodity, bitcoin included. Here were producers facing such a depressed economic outlook that they were literally paying people to take their product off their hands.

Of course, the real price of oil never dropped below zero, although it is trading at inflation-adjusted prices that haven’t been seen in more than seven decades. Rather what occurred was an over-leveraged derivatives market realising that in this particular horror movie the calls were coming from inside the house.

Fill ‘er up?

Oil is a curiosity in that its price is determined not by straight-up supply and demand, but rather on the futures markets. Instead of buying and selling oil itself, speculators are instead buying and selling contracts to purchase oil at a certain price on a certain date. Basically, this means that oil prices are hugely influenced by market sentiment. And on April 20, that market sentiment finally caught COVID-19.

Right now, half the world’s population is in lockdown. Plane travel has essentially ceased and people have stopped commuting to work. In short, our need for oil, the liquid that keeps the world moving, has collapsed. (Unsurprisingly, this has also been a great turn of events for the environment). There is so much excess oil around at the moment that there is literally nowhere to store it.

On April 20, oil traders realised that they were about to be on the hook for a product that no-one needed and that they couldn’t actually do anything with. So they began panic-selling, causing the sort of catastrophic drawdown that made trading bitcoin look like keeping a stash of gold under your bed: at its peak, the price of the May futures contract had dropped more than 300% in a single day’s trading.

A learning experience

There are two takeaways that crypto can, uh, take away from this clusterfarge.

First is a cautionary tale about derivatives trading. Futures, options and margin trading are by their very nature emotion-driven. Unhinged futures are the reason bitcoin dropped 50% last month, as opposed to, say, 30%. These markets are designed to take money from the unwary, the incautious and the overly confident. They require tremendous skill, patience and time to use properly and, even then, events like April 20 can blow your plans out of the water. But that’s a message that tends to get lost when you’re being bombarded with advertising campaigns claiming “100x GAINZ!!!! OMG SIGN UP NOW DOOFUS!”

Second is a reflection on crypto itself. Bitcoin was a laughing stock when it halved in value last month. But since then it’s pretty much back where it was before the crash. Meanwhile, the global economy is being racked by panic selling, currency collapse, debt implosions and deflationary spirals. To try and slow the damage, governments have been printing money, dishing out bailouts and racking up generationally crippling debts. Bitcoin, on the other hand, never stopped trading, never asked for a bailout and didn’t need any financial stimulus. I dunno: maybe you’d call that the most resilient asset in the world.

Now where’s our ETF, dammit!

Ask CoinJar

So, does this mean that bitcoin futures could also go negative?

In a word: unlikely. Part of the reason why the oil futures collapse was so dramatic was because these are actual, physical contracts that are being traded: when the contract hits its endpoint the person stuck holding it needs to find a way of taking delivery. Hence the enjoyable sight last week of an amateur trader on Reddit discovering in real time that the US$26,000 he’d just made buying 1,000 barrels worth of oil futures was about to land him in a lot of trouble. (Given that bitcoin can literally be stored on a piece of paper, it’s hard to imagine it having storage issues at any point in the near future).

By contrast, most of the futures being traded on crypto exchanges are what’s known as perpetual swaps. Rather than having a fixed endpoint when people exchange bitcoin for dollars, they’re rolling bets on the price of bitcoin at any given moment. They are literally derivative: no bitcoin is ever actually changing hands and the futures price is (generally) driven by the price of bitcoin and not vice versa.

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