As the May oil futures contract goes into expiration this Tuesday, April 21, it is down another 36% here on Monday, trading at less than $12 per barrel as of publication of this piece. Meanwhile, the next-month June contract was trading at around $23 a barrel, down nearly 23% since last week following the OPEC+ deal in which participants agreed to cut 9.7 million barrels per day in oil production across OPEC and Russia.
The front-month contract to the second month is trading at a spread of about $10 a barrel, which is referred to as contango when the futures price is above the spot price and means the physical market is in a total state of chaos.
The oil commodity contract is a physically settled contract. In laymen's terms, that means anyone holding the contract will be seeking physical delivery on expiration. The only problem is that on the day of expiration nobody wants that oil as there is simply just too much of it and no space to store it.
It is not feasible to store oil in your backyard, although given the level of contango the 40% trade for one month seems mouth-watering. As long as there is no physical buyer for the oil expiring in May, that price can keep falling until there is a buyer. That is how commodities work. For good or bad, it is driven by actual physical inventory. Fortunately, the Fed cannot manipulate this market, but we have other characters who try to do so but fail eventually.
One may ask if this is a temporary technical failure, and that perhaps we should ignore the price of oil today as the next contract, the June contract, will become live in few days. That is not the case, because the problems existing now still will be there by the time the June contract expires sometime in the middle of May.
The reality is that front-month oil is trading $23 a barrel for West Texas Intermediate (WTI) crude and that each day the oil price averages here the oil companies will face that price for their inventories. This has not been factored into the earnings for the oil majors or some of the more levered exploration-and-production companies.
Most observers are assuming this is just a temporary blip and prices will rally as soon as we are past April. The equity market can take that lead with the Federal Reserve buying (a.k.a. manipulating) every asset class, but the oil market needs actual physical demand.
Even after the global rate of Covid-19 infections peaks and lockdowns end in some countries in May, will life and travel return to normal immediately? Not at all. This is what needs to be priced by the equity markets until a vaccine is developed and demand normalizes at a new lower level, because there still is just too much oil. The production cuts are just buying time ahead of an eventuality. We need to see more and more wells permanently shut down -- not just talked about, but closed.
Commodity prices can trade negatively; it's very rare, but some situations deem it possible given physical dislocations. In Texas there are some landlocked crudes, meaning physical oil is stuck in a region unable to be transported out to be delivered elsewhere. That situation chokes the delivery point, causing prices to collapse.
A subsidiary of Plains All American Pipeline (PAA) bid just $2 a barrel for South Texas Sour on Friday, while Enterprise Products Partners LP (EPD) offered $4.12 a barrel for Upper Texas Gulf Coast crude this week, according to Bloomberg. WTI crude is a landlocked oil. Brent oil prices are more reliable as a global benchmark for oil given it is seaborne and transportable globally in the world if there is demand.
So where is all this extra oil going? Oil tanker shipping vessels are now used for floating storage as an alternative source to hold the oil until prices recover. As of today, storage on vessels has reached 160 million barrels on super tankers called VLCCs that can carry by to 2 million barrels each. The last time floating storage reached these levels was 2009, and now smaller and product vessels are being used to store all this extra oil, too. Because of the contango, traders can buy oil today, store it and hope to flip it at the forward price, if they can get storage economically. It is a game of numbers.
Until that oil can find a home, prices will need to keep falling until more and more producers are forced to involuntarily close production permanently. Once the excess supply is soaked up, prices can stabilize. Recovery is another matter altogether, and that requires actual demand picking up more than what is already available.
