Recent historic moves in oil, with never-before-seen negative pricing, have certainly gotten all the academic institutions focusing on storage, or the lack thereof.
The May WTI Crude contract debacle caused massive physical market dislocations along with retail investors puking out the front contract. The selling was then compounded by the Oil ETF (USO) selling the front contract to buy the second-month contract, causing the spread between the two to blow out from $6/bbl. all the way till -$55/bbl. at one point.
Banks are now reassessing their options pricing models as they never accounted for negative pricing (paging Mr. Scholes?). According to the IEA, they are predicting storage could dry up by June.
Institutions are very good at extrapolating what has already happened, but not what can happen. It is never linear. April was an unusual time when demand shock was compounded by extreme supply as Saudi Arabia and Russia pumped at will. This exacerbated the physical situation in a very short period of time. Now everyone is calling for -$100 prices.
The media has been sensationalizing about oil storage running out. This year, compared to other years, about 3.2 billion barrels of Crude have been placed into storage tanks given the pandemic lockdown has shocked demand in a very short period of time. In 2019, as a comparison at this time of year, about 2.95 billion barrels of oil were in storage, with peaks reaching 3 billion around June and July prior to summer demand activity.
This year the system went through a massive shock in March and April. According to IHS Markit, the total spare capacity for the first quarter of 2020 is around 1.496 billion barrels, with the U.S. accounting for about 371 million.
With global oil demand down 30%, most producers would rather pump even for small amounts of cash than make the painful decision of closing wells permanently, as once this happens, it is very hard to restart if oil prices do stabilize. It is also very costly, which is why they are willing to give their oil away for little money rather permanently close a well.
According to latest figures, Cushing, OK crude stocks now stand at 59.7 million barrels, compared to an estimated working storage capacity of 76.1 mbpd, implying storage is now 76% full, up from 48% five weeks ago and 44% at the start of the year. But while tanks are not full yet, it is important to note that space has been leased out to producers and traders in advance who will fill them soon, so the actual number "vacant" is a lot lower.
Cushing is the delivery point for the WTI oil futures contract, so its physical inventory balance at the date of expiry of the June contract will dictate the price at which it trades. We are now seeing oil doomsday gurus predicting the same fate for June contract as well.
But it is not that simple.
Upon realizing the inefficiencies of the USO Oil ETF and how it is exposed to the difference between the front two contracts, called the roll, the ETF decided earlier this week to change what it holds in its fund. It has now decided to hold 55% of its holdings in July, and 5% in August as well. This changes the mandate of the ETF Oil tracker entirely, as the whole point is for investors to take advantage of "spot." They seem to have taken the loss on the way down, but now will lose out yet again on the way up as we saw the USO down 5% on a day front oil was up 25%. After the May contract expired, this is what caused extreme selling in the June contract last Tuesday evening.
The physical market is still in oversupply as May will see demand fall short off supply, but it will not be as bad as the 25-30 mbpd number as we need to take into account 9.7 mbpd of OPEC+ cuts and demand uplift, albeit small, as economies slowly reopen in May. There are three weeks to go before the June WTI contract expires and it will see weakness compared to the back end of the oil curve, but those predicting a doomsday scenario similar to what we saw in April will be disappointed.
The oil market, or any commodity market, is very efficient, in that when prices trade negative, it is usually for a very short period of time before they normalize as arbitrage players lurking in the corners find a way -- they always do. China is now building storage capacity and is preparing itself to benefit from this situation going forward.
The caveat, or the unknown, is how soon economies open in May. We know travel demand is almost non-existent, negatively impacting jet fuel demand. However, gasoline demand will likely recover as cars get back on the roads, for now.
Sub-$35/bbl. WTI is painful for most of the shale region, including the Permian, Bakken etc. We have seen companies announce production shutdowns, and it is only a matter of when, not if they show up in the official U.S. data. As of this week, DOE inventory data showed U.S. production stubbornly high at around 12.2 mbpd, down from 13 mbpd earlier this year. But this number will soon start falling by the time we get to May.
For the market to stabilize, we need to see about 3-4 mbpd of U.S. oil out, and this requires prices to stay lower for longer. OPEC+ is already in stress and even Russia is announcing production shut-ins of 20%. These are not cuts, one can argue these are involuntary shut-downs. If OPEC cuts too much, prices will rally and help U.S. shale keep pumping, especially given their access to credit and now President Trump talking about making funding available to the energy sector.
Oil prices will never be able to rally sustainably until all this excess inventory is cleared up. It will be a painful adjustment process, but the laws of economics dictate that the higher cost producers go and lower cost ones survive. This is also the law of the jungle.
