The oil price will recover… right?

Well, yesterday’s Exponential Investor went out of date quickly.

A severe bout of teething prevented me from making any last-minute updates. Not me, my daughter. I don’t understand how people raised children before Covid-19 kept both parents at home…

Anyway, back to the oil price. Which didn’t just go negative. It went deeply negative, to -$40. A decline of almost 300% at one point. Which isn’t supposed to happen, right? How can something fall by more than 100%? By going negative…

I explained why this could happen in past Exponential Investors. Once the oil storage is full, having to take delivery of a lot of oil is a liability, not an asset. Would you be willing to pay someone else to take delivery of oil if you had nowhere to put it? I would.

But with nobody willing/able to take delivery, the bid went out of the market. And yet, the sellers still had to sell to escape the prospect of having to take delivery. Hence the seemingly absurd price.

It’s another example of how derivatives can make things go haywire – another topic of past Exponential Investor articles.

Another culprit for the negative oil price is in the news. The US oil ETF USO held about 25% of US oil futures last week according to Forbes. But an ETF doesn’t want to take actual physical oil delivery. It just wants exposure to the oil price, which it gets via futures. This requires rolling over the contracts to the next month as they come close to expiry. Yesterday was the last day to do so. Suggesting that the USO ETF may have had to sell oil futures on Monday, no matter the price.

In other words, this is an example of ETFs making a mess of markets too. Only that narrative is completely wrong according to our own energy expert James Allen. The ETF would’ve rolled over its positions last week, precisely to prevent the event the Forbes article alleges occurred. Which shows why you need experts to understand the world of energy. It’s a confusing place.

By the way, James may be our energy expert, but his eyes aren’t on oil these days. He has put together an event featuring the world’s foremost experts on what replaces oil altogether. You can find out more about it here.

While James thinks two steps ahead, all other eyes are now on how long this weird situation in oil can last. Namely, how many futures contracts get smacked about like the May contract did.

Remember, the futures contract trades oil to be delivered on a specified day in the future. There’s one each month. Yesterday, the oil storage shemozzle sent the May contract to negative because it stopped trading that day. Anyone holding the contract yesterday is stuck with the oil come May. And possibly nowhere to put it…

Today, the oil price becomes the June contract. Which is trading far higher. (No point quoting it here. By the time you get it, who knows what it’ll be at…) The question is, will it get slammed as we near the delivery date too?

For now, the oil futures curve is in an extraordinary contango. Which sounds dramatic, but it’s actually the norm. It means the price of oil for delivery in future months is higher the further out you go. This chart was from Monday morning, before the May crash.

Source: The Market Ear

It’s how much higher that’s unusual – the steepness of that line, the intensity of the contango. The next chart shows the difference between the upcoming month’s futures contract and the subsequent one. Recently that’d be May and June. By the time you get this, it’ll be June and July. As you can see, yesterday’s action sent the gap going bananas. While May had a negative price, June was comparatively normal.

Source: Bloomberg

The worry now is that the June contract will face the same fate as May’s. A plunge as it nears expiry and nobody wants to actually get delivery of the oil. Which seems likely given, if you have brimming oil storage, then the best thing to do right now is hold on to the oil until winter, when the oil futures curve is pricing in a huge increase in the price of oil.

The June contract expires on 19 May. Anyone long the contract will then be required to take delivery of the oil the next month. Suggesting the next implosion of the oil price could happen around mid-May, if there’s another shortage of oil storage then.

So, let’s take a quick look at the storage side of things – the key to understanding the oil price action.

In yesterday morning’s conference call, energy experts James Allen and Kit Winder tried to explain the oil price action to the rest of us. The conclusion from James was that anyone with oil storage space just became a millionaire multiple times over. Because they could secure oil at a negative price, with the prospect of them selling that oil in the future at a high price. The percentage gains on the trade don’t make any sense because that person got paid money to take oil and will get paid money to sell it.

But is oil storage really that tight?

“The available capacity on the oil side is almost completely sold out for our terminals,” said Gerard Paulides, the chief financial officer of Rotterdam-based Royal Vopak NV, which is the largest oil storage company in the world. They’re trying to rush through maintenance to get more storage online.

So it sounds like storage isn’t there. And I don’t see it freeing up come May…

The reason oil stocks haven’t plummeted is that the carnage in the oil market is assumed to be fairly short term given the contango in the futures – future higher prices. And oil companies can stop pumping. It’s the traders who are in trouble, with nobody to sell to and no storage to allocate to.

Although Bloomberg claims that oil companies are worried that ceasing operations damages future productive capacity. In other words, it’s better to sell oil at a negative price now and keep pumping rather than having to cease production now and ramp it up again later.

Trump had proposed paying oil companies to not produce oil. Well, that’s sort of what the market delivered in the end.

But if the recent crash keeps happening towards the end of oil contracts expiring, eventually oil companies will take the hit. They could be in for a few more months of pain yet.

Not that the recent oil price action is the only reason.

Things are getting a little spooky at the Southbank Investment Research offices. Not just because they’re deserted.

In February, our plans began for the event we called “The End of the Bull Market”, just in time for the bull market to end. Next week, we launch an event called “Beyond Oil”, just in time for the oil price crash.

I wonder what’s next…

Nick Hubble
Editor, Southbank Investment Research

Category: Energy

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