Oil's Pyrrhic Victory
There's no defeat quite as galling as self-defeat. This week, the oil market risks this on two fronts.
The first concerns the upcoming Doha meeting of major oil-exporting countries. Expectations of a supply freeze have run hot and cold ever since the idea was first mooted in February. Only a couple of weeks ago, the deputy crown prince of Saudi Arabia threw cold water on the idea during an interview with Bloomberg News. But the mere fact that a meeting is taking place is, for some, reason enough to buy.
The problem -- as it has been since this crash began -- is that any real move to curb supply in order to push up prices risks throwing a lifeline to struggling U.S. exploration and production companies. Unlike OPEC or Russia, they really are cutting output.
It is possible, as Bloomberg View's Leonid Bershinsky argues here, that even a "fake freeze" could support oil prices enough for the sake of countries such as Saudi Arabia but not offer the sort of stability E&P companies (and their creditors) require to crank up production again. Yet managing expectations in the oil market with that level of precision using rhetoric alone is a tall order. The resilience of the U.S. shale industry and its ability to raise financing in the toughest of markets -- just look at Chesapeake Energy's kitchen-sink collateralization deal on Monday -- has confounded OPEC over the past 18 months. Production costs in the shale basins remain a moving target. If OPEC gets it wrong again, higher prices from a freeze, fake or otherwise, could defeat the ultimate purpose of clearing excess supply.
This gets to the second own goal the market may be teeing up. Bullish spirits have helped push up the cash price of crude oil faster than futures, narrowing the spread between them:
This is a problem. As energy economist Philip Verleger pointed out in a report published over the weekend, the only reason oil isn't even lower is because excess supply has found its way into storage. U.S. oil inventories, for example, are at their highest level since the Great Depression.
Like anything else, though, oil only gets stored if it is profitable to do so. This is why the spread matters. When the discount is wide enough, a trader can buy physical oil, lock in a sale in the futures market and, after absorbing costs, still turn a profit. Verleger calculates this theoretical "excess return to storage," or trading profit, to assess the incentive for putting oil into storage or pulling it out.
Using similar calculations, we can see how that incentive has changed over time. Assume that our oil trader likes to buy physical Brent, borrowing 80 percent of the cost at an interest rate of Libor plus 100 basis points (our trader has good credit). They sell the oil six months forward, paying between 40 and 80 cents per month to store each barrel. If the spread covers those costs, they make a positive return on equity and have an incentive to keep making the trade; if not, that barrel should be dumped in the market.
Here's how the annualized return on equity for our oil trader has moved over the past five years (assuming monthly storage fees of 60 cents a barrel):
As you can see, the trade has been highly profitable for much of the period since the crash began in late 2014. Essentially, spot prices have fallen fast enough to keep the spread attractive and ultra-low interest rates have helped on the cost side, too.
But the recent run-up in spot prices has reversed this: At Monday's close, the implied return was negative 36 percent. Lower storage or borrowing costs might help, but neither looks likely given that storage is filling up and the Federal Reserve's next move, whenever it happens, is likely to be a rate increase. Instead, either forward prices have to rise or spot prices have to fall to reopen the spread.
All else equal, the spot Brent price would have to fall 5 percent, back below $40 a barrel, in order for our trader to lock in a positive return of 15 percent. Thankfully for them, that is relatively easily done given the overhang of inventories -- these will be liquidated if the carry trade doesn't work, and that extra oil on the market will tend to push the spot price back down. Until a more fundamental rebalancing of supply and demand occurs, expect these advances in oil to sow the seeds of the next retreat.
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