As we highlighted through H2 2014, we believe that recent turmoil in the oil markets is to do with physical supply and a direct result of the first price war amongst Energy producing nations since 1986, which will be broadly positive for economic growth, but result in a new paradigm in the oil market whereby crude prices remain lower for longer, until at least Saudi Arabia (the lowest cost producer) achieves some or all of its strategic aims. Since the middle of January, however, the price of Brent has bounced by nearly 30% (though interestingly WTI has changed little, which we discuss later), causing some commentators to believe that the oil price weakness was just a short-term correction rather than the beginning of a new bear market.1 We think though, that the spot price of crude has been propped up in recent weeks by opportunistic buying filling up onshore storage facilities (the so-called “storage bid”) and that at the current rate, storage facilities will be full in a matter of weeks. At this point, we believe the spot market will need to fall further (to clear the physical market), leading to a further steepening of the forward commodity curve, which in turn will create more pain for oil producers but opportunities elsewhere in the energy complex.
Chart 1: WTI forward curves
Source: Argonaut, Bloomberg
The chart above depicts the movement of the WTI futures curve from backwardation six months ago into contango. Contango incentives storage as players can buy crude today, store and sell it in the future at a higher price. The cost of storage and the spread in the oil price (steepness of the curve) are the two most important drivers in whether traders can earn a profit out of the contango situation. A steeper curve allows the use of higher cost sources of storage and is reflective of the seriousness of near term oversupply. The chart above clearly depicts this in the recent dramatic steepening of the forward curve.
This year US crude oil inventories are building at an alarming median rate of 7m bbl per week, resulting in total commercial stocks of 434m bbl as at the 20th February.2 According to the EIA total US working storage capacity is 521m bbl – meaning at current build rates, US storage capacity could be full within 12 weeks.3 In fact it could be as little as 9 weeks if we make the not so unreasonable assumption that only 95% of available capacity is actually available from a practical view point.3
As the US rapidly utilises its available conventional storage capacity, near term (spot) oil prices will need to fall further to incentivise alternative and more expensive sources of storage (in order to clear the physical market) such as floating storage and production shut-ins. This steepness can also be shown as a $ / bb /month spread figure (the price difference from one month to the next), which we show in Chart 2 below. In this chart we have also overlaid cost estimates for the different storage options – salt caverns, above ground, floating storage.
Chart 2: WTI forward curves expressed as $ / bbl / month
Source: Argonaut, Bloomberg, Citigroup Global Markets
The two charts above clearly show the supply pressure being brought to bear on the WTI price in the US. Indeed floating storage is now theoretically profitable up to six months out. Interestingly this could have a positive knock-on effect on the rates achieved for tanker owners. Floating storage essentially takes tankers (supply) out of the market, providing upside pressure to rates in an already under supplied tanker market.
If supply continues to enter the market, the crude will have to go somewhere. With conventional storage capacity rapidly running out and floating storage a reality, the WTI curve will need to steepen dramatically (through a fall in near term prices) to incentive the use of the most expensive form 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. In turn this could cause US policy-makers to lift the export ban on US crude, flooding the Atlantic basin and putting downside pressure on the Brent price (as it would need to fall significantly to gain buyers).
However the potential winners of this oversupplied oil market are those businesses involved in downstream operations. Oil refiners in particular are currently enjoying very favourable conditions; so long as the price of crude (input costs) falls more than the price of refined products (revenues). Remember these businesses themselves have significant storage capacity which enables them to buy and lock-in low front month prices, boosting margins and thus profits. This is shown clearly in the charts below, with weekly benchmark indicator refining margins for North West Europe and the US since December 2014.
Source: Argonaut, IEA
In 1986, in response to a collapsing oil price (due to the then oil market price war), the upstream industry cut capex and jobs to protect cashflows. On average the oil majors cut capex by 24%4, with some (like Shell) cutting capex by up to 39%.5 Reduced upstream activity also led to excess capacity in the oil services industry leading to further job cuts (Schlumberger cut its oilfield employees by 35%6), and weak pricing as companies adopted discounting in order to stay competitive.
Interestingly though, during this period, downstream activities and particularly refining businesses enjoyed bumper profits, which to a large extent 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 be creating opportunities for businesses, which for a long time, have been ignored.
1 Bloomberg, 02/03/2015
2 DOE/Bloomberg, 20/02/2015
3 EIA, 25/02/2015
4 Morgan Stanley, 08/01/2015
5 Royal Dutch Shell - annual report, 1986.
6 Schlumberger - annual report, 1986.
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