Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Today's oil market is caught between a conclave of fractious oil officials in Vienna and a president-elect with an itchy Twitter finger.

On one reading, both are positive for oil bulls. Hopes are rising that OPEC, and some chums like Russia, may finally deliver a supply cut to support prices. Meanwhile, Donald Trump's apparent impetuosity doesn't look especially well-suited to the practice of geopolitics, while his apparent desire to open the fiscal taps could spur demand -- well, some anyway -- for all manner of commodities.

But in this universe, for every reaction there's an opposite one.

While the personalities are entertaining, what really rules the oil market is an amorphous blob: The 1.1 billion barrels of what energy economist Phil Verleger calls "opportunistic" inventory held by trading houses.

It isn't gravity keeping this from falling on the market, but a combination of more prosaic financial factors: oil futures prices, borrowing costs and storage fees, to name a few key ones.

Consider: Today, a trader can buy a physical barrel of West Texas Intermediate crude oil for a little more than $46 a barrel and sell it six months forward for about $50.40, a spread of more than $4. On an annualized basis, that's a locked-in return of 18 percent. Not bad.

Running Up That Hill
The near end of the WTI crude oil futures curve slopes up steeply
Source: Bloomberg

Also, not real. Much of the upfront cost will be funded with short-term debt, which carries an interest charge. Also, the oil has to be stored, and unless someone's volunteering their bathtub, that also costs money.

Say our oil trader borrows 80 percent of the upfront purchase price at Libor plus 2 percentage points for 6 months and pays 50 cents a barrel per month to keep it in a tank. On their initial equity outlay of $9 and change, they'll net about 57 cents of profit. That's an annualized return on equity of about 12 percent -- lower, obviously, but more than enough to keep that barrel locked up.

OPEC and Trump could change that.

First, if OPEC secures a deal, then money may rush into oil, particularly at the very front end of the curve. That would squeeze the spread between cash and futures prices, reducing the potential carry from our buy-and-store trade. Second, Treasury rates have already ticked up since Trump's election as bond traders anticipate higher inflation.

Say we add a percentage point to the interest charge and tighten the spread by 50 cents a barrel. The first change knocks 4 percentage points off the annualized return, taking it to just over 8 percent. That's a bit less appealing in a rising-rate environment but still good. But those lost 50 cents on the spread deliver the coup de grace, taking the return to a negative 2 percent.

None of these things move in isolation, so there would be offsets. For example, as barrels exited storage, freeing up space, fees would ease. And the extra oil would tend to depress cash prices again, blunting OPEC's impact and widening the spread again. Also, some traders with the right connections will have access to cheaper tanks and funding.

The bigger issue is that, as Verleger put its, OPEC is taking a gamble with the oil glut when the market math is this finely balanced and demand growth isn't exactly rock solid.

This is doubly so, given that both OPEC and Trump give heart to the world's quickest source of new supply: U.S. shale operators. They've been taking advantage of the recent rally to lay on more hedges to lock in cash flow:

See You Next Year
E&P companies have been selling a lot more oil forward to lock in cash flow
Source: Bloomberg
Note: Nymex crude oil producer and merchant short contracts.

Two separate surveys published on Monday by Grant Thornton and Raymond James both indicate America's exploration and production companies are, in general, getting ready to spend more on drilling in 2017.

And with Trump apparently in favor of drilling just about anywhere, while OPEC is seemingly ready to make room in the market, why wouldn't they?

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net