All you need to know about settlement price

Amid all the havoc wreaked by Covid-19, a recent episode related to the heavy losses borne by the traders in crude oil futures contracts on the MCX last week.

Reacting to depleting demand and a lack of storage space for crude, futures price of the WTI Crude Oil contract expiring on April 20 entered negative terrain. Investors trading crude futures on the domestic MCX felt the ripple effect of this as their settlement prices turned negative too, leading to unforeseen losses.

Futures are derivative contracts that allow you to buy or sell the underlying asset (a stock, index, commodity etc) at a future date. Futures contracts are standardised and can be traded only in lots of a specified quantity. On expiry, the buyer of the contract either delivers the underlying asset (physical delivery) or pays the seller cash to settle the contract value.

The difference between the buy price and settlement price makes up the profit or loss on the trade.

In the Indian markets, futures on equity stocks are compulsory delivery contracts. For futures on commodities, SEBI mandates physical delivery for bullion and base metals alone.

Futures on all other commodities can be either cash-settled or delivered physically. For commodities, exchanges specify the settlement price, which is also called due date rate (DDR).

For most agri commodities, the exchange determines the DDR as an average of the spot prices of the last few trading days when the contract nears maturity.

Last week, traders on the MCX platform were left with a large loss on their April month futures, after the exchange announced its settlement price for the crude oil future contract as minus ₹2,884 per barrel. This was computed based on the settlement price of the global contract that it mirrors, the NYMEX WTI crude future which stood at minus $37.63 a barrel.

The MCX WTI crude oil contract essentially reflects the NYMEX contract and the negative settlement price was based on the prices of the next-month futures (May) on WTI crude oil traded on the NYMEX.

The NYMEX settlement dipped into the red after there was acute shortage of storage capacity for crude oil at the delivery point in Cushing, Oklahoma, both floating and land storage.

Due to this, buyers of open long (buy) positions on May month WTI crude refused to take delivery on the expiry and instead agreed to pay the sellers for this refusal.

On the NYMEX, buyers get to either take delivery of the underlying on expiry (physical settled) or cash settle it, before expiry date. With the pandemic decimating demand for crude oil, buyers were already sitting on huge oil stock and simply could not take any more of it. This unprecedented move of the buyers had pushed the crude oil futures prices into the negative terrain, ending at $37.7.

If you thought your petrol pump dealer will pay you to refill next time, banish that thought. Indian pump prices have little to do with WTI and are pegged to domestic import prices which are certainly in positive territory.

Plus, sizeable taxes levied by the Centre and the States add to the retail price. For those trading energy futures, the strange phenomenon may continue.

With most nations still under lockdown, experts believe the rout in global crude prices may well take the future prices of WTI crude to below zero in future too.

Hope the Indian participants and regulators can work their way out of this before it is too late in the case of contracts expiring in the coming months.

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