1) The document analyzes the extreme price drop in the May 2020 WTI oil futures contract in mid-April 2020, where the price went negative for the first time. 2) It suggests the root cause was a lack of liquidity as big financial players had exited before expiry due to risk policies, leaving retail investors and a gap without real buyers or sellers. 3) It raises concerns that some Chinese retail oil contracts may have been designed in a way that allowed the banks to retroactively force close positions if prices moved against clients, potentially profiting from the move.

1. Eureka?
insights by Pentathlon Investments
BAO versus WTI

2. Warning Sign #1: The Price Action
NY Time May 2020
Price
June 2020
Price
What
happened?
April 20 –
10:00 AM
11.40 22.70 BAO stops
trading
April 20 –
13:45 PM
0.00 21.79 May goes
negative
April 20 –
14:30 PM
-37.63 20.43 CME
settles
April 20 –
20:00 PM
0.00 21.68 May is
positive
April 21 –
14:30 PM
10.01 11.57 CME
settles
While Storage was a catalyst, the root cause is in the financial derivatives market.

3. • The linkage is via carry trade:
• Buy physical
• Sell futures
• Pay storage costs
• Pocket the difference if positive.
• Financials can only buy futures and must
roll them before expiry often pushing
futures above spot – “contango”.
• Negative roll hurts investors but
compensates storage holders for their
service.
• The higher the storage cost, the steeper
the contango, the higher “investors fee”.
• Over last ten years spot oil price was
unchanged while owning futures lost
$75/bbl (before April).
• Most investors roll early to minimize the
damage but very few play it until the end
(expiry).
Storage Links Physical and Financial Markets
-100
-80
-60
-40
-20
0
20
40
60
80
Oil: Spot vs Futures (Jan 2009-Mar 2020)
Spot Price Change Futures Profit/Loss

4. Who is left in the market before expiry?
1) Storage owners
• Hold Calendar Spread Options (CSO, also called “synthetic” storage)
which settle at 2:30 on 04/20.
• CSO might make up a large portion of open interest the day before
expiry but only contribute to price action when strike prices are
crossed.
• Risks are offset with futures close to 100% around expiry.
2) Banks and over-the-counter dealers
• Hold shorts futures against over-the-counter (OTC) average price
swaps and some options bought from producers.
• Liquidate futures ratably at CME settlement prices. Futures offset
OTC risks.
3) Neither large physical trading houses nor large financial investors are
involved that late due to rigid internal processes, risk and position limits.
4) But some small buyers are trying to outsmart the market at the buzzer.

5. Warning Sign #2: The Liquidity Gap
Key facts about May WTI:
• May is “special” due to storage capacity constraints.
• However, at $5-7/bbl discount to June the storage was still available. At $58 discount to
June, one can store small volumes in the backyard, and the volumes were indeed small.
• Open May futures interest coming into April’20 was 108,593 contracts.
• Total open interest of CSO puts (WA contract) which automatically convert into futures
was 63,550. Nearly all of them were fully hedged.
• Total volume traded directly at settlement price was 77,076. Most of it traded earlier during
the day and included all CSO-related activity as well as banks liquidating their ratable
producer hedges.
• Open interest at the end of Apr’20 dropped to only 13,044.
• When there is nobody left, and one sells futures into the vacuum then price craters.
The Bottom Line:
1. Once Accounted for all price neutral hedgers, the real risk changing positions were very small
2. When there is nobody left, and one sells futures into the vacuum then price craters
But what if this is what you wanted?

6. Example: “YuanYouBao” (Crude Oil Traders)
• Issued by Bank of China for retail customers for WTI and Brent, could
be in either USD or RMB.
• Bank of China holds the futures, but clients have domestic off-
exchange contract with BoC.
• Clients make decisions, executed via BoC but must stop trading at
10:00am time (22:00 Beijing) on 04/20/2020, one day before CME
contract expiry.
• The product is claimed to have no leverage (technically impossible for
futures) which means margin is posted for the full notional amount of
futures.
• If you are long futures and price is above zero, then it covers. If price
goes negative, then it does not.
• BoC recent ad says that “Oil is cheaper than water, BoC takes you to
trade” which brought a wave of fresh buyers.
• One investor who bought 20 May WTI contracts at 194.23 Yuan / USD
27.50/bbl which was settled at minus 266.12 Yuan / minus USD
37.63/bbl lost RMB 9.2 million, much more than notional.

7. Extracts from “Crude Oil Treasure” Contract
• “The personal account commodities business is a commodities trading tool that the
customer uses the quotation and trading platform provided by the bank to deposit a
transaction margin equal to the nominal amount of the opening currency in advance to
realize the two-way selection of long and short …This product is a commodity margin
trading business that does not have a leverage effect, and belongs to a trading product.
• “Compulsory liquidation: refers to the behavior that the bank has the right to take the
initiative to close the position on behalf of the client when the floating loss of the client's
unclosed contract causes the margin adequacy ratio of the special trading account to be
below the bank's prescribed ratio.”
• Normally, the contract settlement date is the last trading day before the contract expiration
date.
• Shifting position: On the settlement day, the bank will freeze the customer's special
trading account, and will carry out the expiration of the client's position shift operation
according to the settlement price of the current contract and the next contract of the
personal account commodity product announced by the bank.
Bottom Line: The bank appears to have the right (but not the obligation) to force closing the
position.

8. Warning Sign #3: Optionality Monetization Or?
“Bad” Trading: Monetizing Contract
Optionality
• Investors “forgot” to roll – but they never
forgot before and there are over 3,000 of
them, is it plausible?
• Traders tried to “monetize the customer’s
option”
• Do not do anything at 10am at $11.40/bbl or
even later at zero waiting for the price to pop.
• If the price does bounce then exercise your
right to force client liquidation retroactively
at 10:00am price, then sell in the market at
higher price, and possibly profit from the
difference.
• If the price does not bounce, then the exit the
trades at 2:30 (at -37.63), use this price to
settle the contract with the client, and point
fingers to CME.
“Smart” Trading: Playing a Bigger game
• Since there is nobody left, there is a
unique opportunity to sell aggressively
into the vacuum and achieve ridiculous
settlement price by spending relatively
small dollars which may not be even
yours.
• But why ?
Think About Possible Implications:
• Buyer’s confidence in US oil is destroyed
leading to structurally lower prices
• The stability of US financial markets is
shaken
• US shale industry is destroyed

9. Thoughts? Please e-mail us
to Pentathlon Investments at
ib@pentinv.com