How many people could find Cushing (population: about 8,000) on a map? Maybe a few more since the small town in Oklahoma took centre-stage in an unprecedented panic in the oil world. Within a few hours the reverberations were being felt thousands of miles away in China as well.
Tank farms with about 80 million barrels of oil storage make Cushing the main delivery point for the crude underlying some of the world’s most actively traded oil futures contracts. And that meant that the town was also ground zero for the spectacular collapse of a product called ‘Yuan You Bao’ (literally: Crude Oil Treasure) that had been sold to thousands of clients of one of China’s leading banks.
Investors in China are blocked from trading in the international futures markets but Yuan You Bao gave them a way of betting on changes in the oil price through contracts linked to West Texas Intermediate (WTI) and Brent Crude.
Typically holders of the contracts take the chance to roll them over into a future period or settle their positions and exit the market. But the unprecedented uncertainty in the oil market meant that there were no buyers when last month’s contracts came due on April 20.
Investors were then faced with an unenviable situation in which they were required to take possession of a thousand barrels of oil for each contract. With the oil tanks filling up furiously in Cushing, Bank of China searched desperately for other traders to buy the contracts. But they charged the bank punitively for the privilege, with the price of WTI oil dropping to minus $37.63 at the peak of the panic.
Investors back in China then woke up to the fact that they had not only lost the full value of the contracts but were on the hook for the additional costs of selling the oil as well, with the bank sending them a bill for the shortfall.
They were furious. Holders of the contracts had been required to back them with an equivalent amount of cash, so they had assumed that this was the theoretical limit of their potential loss. But in fact, it was much worse: one university student in Hunan told Reuters how she had lost Rmb183,000 ($25,895) on an Rmb70,000 investment. “That’s all my scholarship money and savings,” she lamented. “I haven’t told my family yet, and I hope to issue complaints to the China Banking and Insurance Regulatory Commission to protect my rights.”
Bank of China put out a statement saying that it was “deeply disturbed” by the situation and that it would do its best to protect its clients’ interests.
Admittedly, it wasn’t the only victim of the wild gyrations in the market. Investors in other countries were on the wrong end of the contract crunch as well and oil futures dropped dramatically again at the start of this week, when the world’s biggest oil fund sold its June positions and announced plans to buy longer-term contracts.
The US Oil Fund said it was changing approach because of new limits imposed by regulators.
However, Bank of China seems to have got the worst of the situation. Initially it acknowledged losses of about $85 million for 3,700 retail investors, although the total was revised upwards to more than Rmb9 billion ($1.27 billion) by the start of this week, according to business magazine Caixin.
The main criticism of the bank is that it had plugged in a settlement date for the contracts only a day before they were due to expire, which left little room for manoeuvre once the pricing started to go haywire.
Clients of other banks had rolled over their futures at earlier dates, the Chinese media noted.
Nor should it have been quite so blindsided when things soured at settlement. On April 8 the commodity exchange operator CME Group had relayed plans for scenarios in which energy prices “continue to fall toward zero” and a week later clients were given the chance to test their handling of contracts that needed to be settled in negative numbers.
Another gripe is that Bank of China should have done more to educate its investors on the potential pitfalls in their investment. It says it sent messages by text and phone to remind them of the risks in fluctuating prices. But the local press says that many of the holders were simply betting that the oil price was going to go up from record lows and that they had little understanding of the mechanics of the contract pricing.
Products like these have been sold to tens of thousands of customers of China’s leading banks, Caixin adds, with contracts split up into tiny tranches that allow for investments of as little as a few yuan.
Advertisements for Yuan You Bao on WeChat were targeting a relatively unsophisticated market, with Bloomberg reporting images of golden barrels of oil under the caption: “Crude oil is cheaper than water”.
Investors caught up in the crisis have been active on social media, saying they shouldn’t have to make good on their losses. Others claim to have received commitments that the bank won’t chase them for outstanding cash, according to China Securities Journal. Of course, that reinforces the old problem of moral hazard in which people still expect the state to come to their rescue in moments of financial disaster.
The situation also raises questions about the sale of wealth management products in general and whether their clients always understand what they are buying. That could become more important in a context in which regulators are opening up the financial sector to more foreign involvement, bringing a wider range of choices for domestic investors. More cases like the collapse in the oil contracts will put pressure on the government to prioritise investor education or risk situations in which foreign financial services firms are accused of exploiting their new customers.
In this particular instance Bank of China is the target of most of the ire, although there have been a few mentions of how short-sellers twisted the knife during the search for last-minute buyers.
In the meantime other banks have stepped away from similar products, with lenders such as ICBC and China Construction Bank closing their oil trading products to new investment. That’s a prudent decision: traders are already jittery about the next round of oil futures due for settlement in June, with prices falling more than a quarter on Monday.
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