Super Contango

John Leiper – Head of Portfolio Management – 24th April 2020

In an unprecedented day in the history of oil trading the price of the front month contract for West Texas Intermediate (WTI) oil fell below zero to -$37.63.  

On mobile: review chart in landscape mode

Whilst that is clearly exceptional, it is important to apply some perspective.

The price went sub-zero for a short period of time, two days, and applied exclusively to the May derivative contract in the run up to expiration on Tuesday 21st April. Further out the contract curve the price of oil remains positive.

The likely cause is a combination of three factors: the collapse in demand following the outbreak of the coronavirus, surging oil production and the fact storage space is running out fast.

This week these three factors converged. The catalyst seems to have been news that a storage facility in the US ran out of future leased storage capacity for the month of May. As a result, traders faced a conundrum over where to store oil. With limited ability to do so, the price dropped markedly.

What is interesting, is the storage issue has been known about for quite some time. So it doesn’t fully explain the dramatic drop in prices.

Another explanation relates to speculative traders who trade oil to make money from changes in price and do not wish to take physical delivery. These traders need to sell their existing position and purchase, or ‘roll’, into another contract prior to expiration date. This ordinary process, of rolling-over futures contracts, has been made far more difficult, and painful, by the lack of storage. As shown in the chart below, on the 14th April, the difference in price between the May and June contract was just over -$7. This means that ETFs, like the United States Oil Fund, were losing $7 for each contract rolled over. When the June contract is trading around $14 that’s a huge 50% discount. In fact, it got much worse than that as the spread between the May and June contracts reached a low on 20th April of -$58.06. This isn’t on the graph…because it wouldn’t fit!

On mobile: review chart in landscape mode

Setting aside these technical issues, the catalyst, concern over storage space, stemmed from just one storage facility in the US. Therefore, the question is what happens to the price of oil when the world actually runs out of storage – a distinct possibility. Official numbers are a little hazy, due to the secretive nature of the oil industry, but most research analysts believe global storage facilities could be completely full by June. If so, we may see further selling of the June contract. As shown in the chart below, the price of WTI oil for June delivery (white line) has also fallen noticeably, alongside falls in the July, August and September contracts.

On mobile: review chart in landscape mode

Given storage space is effectively fixed, and the coronavirus induced lock-down means demand is unlikely to pick-up in the immediate future, the real driving force behind this move in oil prices is supply.

This is where Saudi Arabia comes in. Saudi Arabia, the world’s largest oil exporter, is intentionally flooding the market with oil. It is doing so to assert dominance and gain market share, despite the superficial OPEC+ agreement to do the opposite. This is not what the global economy needs. Higher oil prices would provide stability and put US dollars in the hands of those emerging market countries that lack it. Nonetheless, the strategy seems to be to push oil prices ever lower to drive competitors such as Russia, Iran and Iraq out of business. Saudi Arabia has deep pockets which means it is in a position to do so. If successful, competitor producers, which produce approximately one-fifth of global output – could go offline, in some instances for years. In that scenario, Saudi Arabia is well placed to pick-up the mantle as the only game in town (except US shale) and extract monopolistic rents from its new position of privilege. For this scenario to take place, Saudi Arabia would need to fully commit to the plan, storage facilities would need to remain saturated and the coronavirus induced lock down would need to continue ensuring demand remains low. Not unreasonable assumptions…

Meanwhile, oil importers should also stand to benefit from lower prices. Within this group China stands to benefit the most. It is unique in that it has the capacity and ability to do so. In the first quarter China took advantage of lower oil prices by doubling the amount it imported relative to the same period in 2019. There are now strategic plans to extend purchases further and to expand strategic storage sites which also acts as economic stimulus by spurring construction projects. We currently hold a position in Chinese equities and last month we rotated a portion of our emerging market exposure towards oil importing countries.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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