May 04, 2020 [Seeking Alpha – Published on April 28, 2020] – Market attention has focused on the recent downside implosion of the May WTI contract into negative territory. While historic, the current term structure of oil markets is largely a function of fundamentals. Massive supply/demand imbalances highlight the depth of the global economic slowdown and the inability to rationalize supply.

 
While the carnage in the May WTI contract garnered no shortage of media and Twitter attention, unpacking what happened is instructive on several levels. For those who missed the action on April 20, I’ll set this up for you. The May WTI contract was set to expire on April 21, after which the June contract would be considered the front-month contract. Typically, most large exchange-traded products (ETPs), as well as institutions that track and own the front month, make their own rolls at some point between a few days and a couple of weeks ahead of the exchange roll. Popular retail ETF USO already had rolled to the June contract before the week even started.

On April 20, May WTI traded lower all day, until crossing the $0 threshold in late afternoon. Further history was made as the contract traded as low as -$40, before rebounding in the after hours. So, what exactly happened here?
 

Defined Storage Limitations

Global oil storage is near full. Demand destruction as a result of the economic shutdown catalyzed by CV-19 is in the order of 20-29 mm b/d. Emergency OPEC cuts that begin on May 1 will only take about 40% out of this massive supply/demand imbalance. That is, if cartel compliance is strong.

The EIA recently reported data from April 17th.

U.S. domestic production is still a whopping 12.2 mm b/d. Imports have dropped to just over 2mm b/d, but reports that 20 VLCCs carrying about 40 mm barrels are en-route to the U.S. from Saudi Arabia. These are expected to arrive between April 21 and June 1. The problem is that U.S. storage is entirely full.

Cushing is reported to have storage capacity of around 76 mm barrels. DOE data from April 17 indicated storage levels of just under 60 mm barrels in Cushing tanks. However, it’s common for much of capacity to already be spoken for by large shippers and refiners. This would explain the massive contango between front-month WTI. But why did the May contract go negative?

Several potential explanations abound. Goldman Sachs postulated a theory that retail futures accounts were caught the wrong way on margin calls. While Interactive Brokers announced an $88 mm loss as a result of clients not meeting margin calls, most retail brokers prevent clients from trading the front month within a few days of the contract roll.

A more likely explanation is that less experienced institutions bought the May contract between the 17th and 20th of April with the intention of taking delivery and selling the June contract to capture around $6 in contango profits. This works in theory, until you make the call for storage and find out that it’s been entirely pre-booked.
 

Why This Matters

Massive short-term losses realized through an incredibly disorderly market are just one piece of the puzzle. All data suggests that the world is choking on oil. Tanker rates have exploded higher, as much of the world’s shipping fleet is hired at almost any cost to store oil. Below is a chart of common tanker pricing benchmarks.

These rates are so high that many oil shipping companies will generate free cash flow that represents their entire market cap with rates at just 80% of the above.

The contango in Brent oil tells the same story with a $12 six-month contango. This spread allows a speculator to pay up to $140k/d for a VLCC over six months to break even.

All of the data suggests that the issues in the oil market are more fundamental than technical. Another round of OPEC cuts or further SPR fills will not address the issue at hand – there’s simply too much production, both in the U.S. and globally. Oil demand is a barometer of current economic conditions. Demand will indeed increase somewhat as economies slowly begin to open up in the months ahead. However, supply will need to be right sized. In the U.S. shale patch, this means a bankruptcy and well shut-in cycle that will could mark the end of U.S. oil independence, and the culmination of shale’s role as the global swing producer.

Foreign producers that rely on the sale of crude to finance state budgets will be reluctant to cut production meaningfully in the near term. The social contract implies perpetual state oil revenues. In many ways, this has been the legacy of OPEC.
 

Opportunities

Based on the dynamics described above, a number of long trade setups have already begun to work. Shares of crude tankers, a cyclically dysfunctional and disliked sector, are showing substantial gains over the last month. For most shippers, current time charter rates will result in FCF generation approaching half of market caps over just six months.

Consider a likely scenario where E&Ps with weak balance sheets and poor business models shut in production, with some being forced into restructuring. Producers with strong balance sheets will have the opportunity to acquire assets at bargain prices, without the suffocating debt that many small and mid-cap producers were forced into.

This will leave a smaller group of E&P companies in advantaged positions as natural recipients of E&P capital. At the same time, the opportunity to acquire both acreage and production facilities simultaneously from distressed E&Ps will make the strong even stronger.

The market may have just begun pricing this dynamic, with shares of strong, large-cap producers outperforming highly levered shale players. The best cure for low prices is low prices, and as this situation plays out, it’s worth considering who will come out as winners.
 

In Summary

The recent carnage in front-month WTI market attracted media attention like moths to a flame. However, this event should be considered a symptom of a paralyzed global economy that’s unable to rationalize a petroleum supply network that is very difficult to shut in.

As the Fed and the U.S. government continue with their converging monetary and fiscal programs, the energy sector presents a conundrum. The once-powerful industry is seeking bailouts, as are the lenders that financing this business. On one hand, energy security is a national interest. On the other, bailouts will only serve to extend the dramatic energy oversupply scenario and delay any meaningful supply response.

With global central bank intervention, the utility of free-market pricing mechanisms has been compromised. Looking to real world supply/demand imbalance proxies is informative. After all, the Fed can’t print more storage tanks.

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