The imminent end of crude’s dead cat bounce
The recent turmoil in the oil markets is to do with physical supply and a direct result of the first price war among energy-producing nations since 1986.
While broadly positive for economic growth, the turmoil will create a new paradigm in the oil market. Crude prices will remain lower for longer – or at least until Saudi Arabia achieves its strategic aims. The price of Brent has bounced by nearly 30% since mid-January, leading some to believe the oil price weakness was a short-term correction rather than the beginning of a new bear market.
However, the spot price of crude has been propped up by opportunistic filling up of onshore storage facilities. At the current rate, storage facilities will be full in a matter of weeks, whereupon the spot market may need to fall further in order to clear the physical market. This will lead to a further steepening of the forward commodity curve and cause more pain for oil producers – but may elicit opportunities elsewhere in the energy complex.
Chart 1: WTI forward curves
Source: Argonaut, Bloomberg
Chart 1 depicts the movement of the WTI futures curve, from backwardation six months ago to Contango. Contango incentivises players to buy crude, store it, and sell it in the future at a higher price. The two most important drivers of potential profit are the cost of storage and spread in the oil price. A steeper curve allows for the use of higher cost sources of storage and reflects the seriousness of near term oversupply.
This year, US crude oil inventories are building at an alarming median rate of 7m barrels per week, resulting in total commercial stocks of 434m barrels as of the 20th February. According to the EIA, the total US working storage capacity is 521m barrels. At current rates, US storage capacity could be full within a few weeks if we reasonably assume only 95% of capacity is practically available.
Near term oil prices will need to fall further to incentivise alternative and more expensive sources of storage, such as floating storage and production shut-ins. This steepness can also be shown as a $/barrels/month spread figure (the price difference from one month to the next), as in Chart 2.
Chart 2: WTI forward curves expressed as $ / barrels / month
Source: Argonaut, Bloomberg
The above charts show the supply pressure on the West Texas Intermediate (WTI) price in the US. Floating storage is now theoretically profitable up to six months out, which could positively impact tanker owners. As floating storage essentially takes tankers out of the market, it provides upside pressure to rates in an already under-supplied tanker market.
Crude will have to go somewhere if supply continues to enter the market. With conventional storage capacity running out and floating storage a reality, the WTI curve will need to steepen dramatically through a fall in near term prices. This would incentivise the use of more expensive forms of storage: in the ground or physical shut-in. In this scenario, upstream capex and oil service industry activity would be almost non-existent, and marginal producers would file for bankruptcy protection. US policy-makers might then lift the export ban on US crude, flooding the Atlantic basin and putting downside pressure on the Brent price.
Businesses involved in downstream operations are potential winners of the oversupplied oil market. Oil refiners are enjoying favourable conditions; so long as the price of crude (input costs) falls more than the price of refined products (revenues). These businesses have significant storage capacity and can buy and lock in low front month prices, thereby boosting margins and profits. The charts below demonstrate this, with weekly benchmark indicator refining margins for North West Europe and the US since December 2014.
Source: Argonaut, IEA
In response to the 1986 oil price collapse, the upstream industry cut capex and jobs to protect cashflows. The oil majors cut capex by an average of 24%4; some cut capex by up to 39%5. Reduced upstream activity also led to excess capacity in the oil services industry, causing further job cuts and weak pricing as companies adopted discounting to stay competitive.
Interestingly, downstream activities – particularly refining businesses – enjoyed bumper profits during this period. This helped offset the decline in upstream revenues for the majors. Today, downstream assets and their revenues are mere footnotes for most energy investors. However, this supply-led shake-up of the oil markets, which has not been seen for almost thirty years, may once again create opportunities for businesses, which for a long time, have been ignored.
Greg Bennett is fund manager at Argonaut Capital