06 Apr Dance the (Con)Tango — Making Money With Cheap Oil
I was recently contacted by a friend in Germany seeking some insights into the current oil market. What happens when the supply of oil overshoots the demand for oil? This post explores the curious world of contango oil markets.
A Messed Up Market
My friend works mostly in auto manufacturing, and is tracking the automotive industry’s transition to alternative fuels and new electric drive trains for his clients. He is keenly aware that there are 1.2 billion cars on the world’s roads, that we can make at best 100 million new cars each year, and that 50 million of those cars supply the growth in demand. The rest are replacement vehicles.
In other words, to overhaul the fleet of 1.2 billion cars will take a minimum of 12 years, once the entire manufacturing supply chains are reconfigured. Oil for transportation is going to be with us for at least a decade but the current pricing is alarming. He was curious to understand the dynamics in the oil markets at the moment, how long these conditions might prevail.
Like any commodity market, supply and demand forces in oil are influenced by price signals. A low price causes suppliers to shut in production and consumers to buy more. A high price encourages new oil production and reductions in petroleum purchasing. Oil producers are reluctant to shut in production because there can be negative consequences—some reservoirs may be irrecoverably damaged if they are shut in. Expanding production takes time and capital. Consumers can’t easily modify their behaviour either, by moving closer to work or downsizing their vehicles, although they can buy bigger vehicles and drive more. As a result, it can take some time for the price signal to work its way through to production through the very long and complex petroleum supply chain.
The root cause of the instability in the market seems related to the growth of the US oil sector, which has grown mightily for several years on the strength of two innovations — multi-stage hydraulic fracturing of tight resources, and horizontal drilling. All the growth in oil markets globally, and then some, appears to have been captured by these US producers. Of course, the US is not exporting all that bounty, but the country, which had been dependent on oil imports for decades, suddenly no longer needs as much imported crude. The displaced imports must now seek out new international markets (and only Asia features demand growth), which usually means price discounts to attract new customers.
Today’s situation is further aggravated because the response to the pandemic has been to shut down non-essential business activities. So far, oil demand has fallen by 10% in March, a huge drop in a market that grows by a mere 1-2 million barrels per year. Analysts think another 10% decline is coming in April, which collectively turns into annual decline of 5%. It’s like erasing half a decade of growth in 2 months. At the same time, an arrangement between OPEC, led by Saudi Arabia, and Russia, to collaborate in managing global supply volumes to prop up prices collapsed. In response, producers decided to flood the market with oil.
I reminded my friend that unsold oil is placed into storage somewhere. Oil storage assets are rapidly filling, creating a huge market overhang. Now oil traders are even booking crude oil tankers to stockpile crude. Generally ships only make money when they’re moving, and using a ship as a floating storage tank is hard on the ship (marine life grows on the underside).
Backwardation and Contango
The price of an asset (a financial asset or a commodity), which is bought and sold for immediate payment and delivery, is called the spot price (because you can buy it on the spot).
Buyers and sellers can also agree the price of a commodity in the future to give some certainty over the price down the track. This done through a futures contract, ie, a type of contract agreement between a seller and a buyer of a commodity that closes and settles in the future. Futures contracts include the specific commodity, the amount of the commodity to be transacted, when and where the product will be delivered, and the price. Oil refiners use future contracts to lock in feedstock supply for their operations because shutting down a refinery is a costly event. Using futures contracts and physical supply contracts oil refiners can gain some certainty over their costs of supply.
Futures contracts are tied to the monthly calendar, and stretch years out in the future. One of the features of futures contracts is that you can enter into them with no intent of ever having to buy the commodity and hold it for delivery, provided you can eventually sell the future contract to someone who can.
Normally, the spot price is above the future price. Anyone buying oil on the spot market is doing so because they have an urgent need and are prepared to pay more. Perhaps an inbound cargo is delayed because of a shipping problem. Perhaps traders might assume that there will be plenty of oil available in the future since production is usually growing, which suggests a lower future price. This type of market is called backwardated (spot higher than future). Most commodity markets tend to show backwardation.
But sometimes the spot price is below the future price, and is called a contango market. Oil markets today are strongly contango. Traders therefore assume that the future price will likely be higher than today’s price.
What will the oil price be in the future? The average long run price of oil is USD$30/barrel. Futures market suggests oil markets to be around $40.
Buy Low, Sell High
Chartering a tanker to store crude oil is a buy-low now, sell-high later strategy. Buy it today at the low price, enter into a futures contract to sell it to someone in the future at the agreed high price, moor up the cargo in some safe harbour (Singapore), wait, and eventually pocket the profit.
And the profits can be substantial. A very large crude carrier (or VLCC) holds about 2 million barrels (mmbbls) of crude oil. A contango spread of $15/barrel on a 1 year contract is $30m (the spread times the volume) minus costs (daily charter costs, moorage fees, load and unload charges, carrying costs, insurance). This play works when the spread is big enough and the charter rates of the tanker are low enough. In February, a time charter on a VLCC was $40,000/day. Last week they ramped up to $300,000/day.
Smaller vessels have higher day rates on a per ton basis, but there’s lots of them. My math is that the spread isn’t quite big enough to prompt a lot of smaller ships in a contango play, hence we’re only seeing media stories about really large ship contracts. This might change the longer the pandemic pain lasts.
And you don’t need ships (in fact, ships aren’t the best option since they tend to deteriorate when just sitting around). This works with any liquid storage asset like above and underground tanks, salt caverns, some mines, and depleted reservoirs.
It’s very challenging to figure out how much oil is going into storage, and equally importantly, how it will be eventually released for delivery. Many governments hold strategic petroleum reserves, private players such as very large oil companies, traders, and midstreamers have operating stock holdings, as do national oil companies, making for lots of contango market play potential.
An example private storage asset available for rent is at Saldanha Bay, South Africa, a 45 mmbbls strategic asset built by the SA government during the apartheid era. Recent media reports suggest that it was getting full.
Suffice to say, oil storage is in the billions of barrels, and its rapidly rising price is a sign that storage is becoming scarce.
The Dark Side of Contango
The futures market is a key element in helping manage commodity pricing. However, the problem down the road is unwinding contango cargos. Today’s oil in storage is a huge asset that eventually will need to be released into the market. When that happens it can further depress prices. This won’t be good for oil producers seeking capital to expand production.
Advice to a Friend
My closing thoughts to my friend were:
- The fundamentals of demand (lots of hydrocarbon-based transportation, petrochemicals, plastics) may be moribund but are intact.
- With no clear signs yet about the end of the pandemic, demand is going to be uncertain.
- With no path forward for Russia and Saudi Arabia to resolve their differences, oil market supply remains uncertain.
- The huge build up of oil stocks will take many months to unwind, potentially playing a foil to improve prices.
- There will be bankruptcies among the oil producers, but national governments will be pressured to support their energy industries as a matter of national security.
- The suppliers of goods and services to the industry, who suffered the greatest losses in the last market adjustment (2014), will be hammered hard.
- Watch the oil futures market for clues about the future price of oil, the resumption of demand, and the reinvigoration of supply.
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