Crude Oil Inventories: I Can Tango, Can You?

The EIA released crude oil inventories and…..surprise, surprise, inventories were larger than expected. (Insert sarcastic scoff here) The mechanics in the oil market have created an incentive to store oil and sell it in the future. The contango, or what some have deemed “super-contango” in the oil markets, has the tank farms in Cushing, Oklahoma at extreme levels. Storage space is so tight that speculators are chartering Very Large Crude Carriers (VLCCs) as floating storage tanks.

Looking at the weekly inventory data from Cushing, Oklahoma, or as the EIA so bureaucratically calls it PADD 2, it is clear to see the dramatic increase in oil storage beginning in November 2008.

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The blue lines on the chart above indicate the average inventory for any given month - they can be thought of as average inventory bands. It is fairly obvious that the inventory levels in Cushing are well above the averages and do not appear to be abating.

The culprit is contango – a funny name, with BIG implications. As a refresher, contango occurs in the futures market when the near month contract is trading below the far month (typically one month and 12 month). Currently WTI crude oil for February 09 delivery (CLG09) is trading at $44.96, while WTI for December 09 delivery (CLZ09) is trading at $59.60. This means that investors can purchase oil for delivery in February, store it for nine months and realize a profit of $14.64 per barrel, less storage and financing costs. Isn’t financing what got us into this economic mess in the first place?

It is, indeed, and it is why, at this point in time, the contango is so large. Normally, speculators would arbitrage away any excess gains that could be had by playing the oil curve. However, many of those same speculators cannot get the financing due to the ongoing credit crunch. What’s more, those who can get the financing are having a tough time finding storage. The result is “super-contango”, which, much like garlic, can have lasting effects. The most extreme could be oil producers shutting in production and using it as “in-ground” storage.

The most logical extension of these developments would be that the supply destruction, or hoarding for storage, will cause shortages, the nearby oil contract will rise and holders will sell stored oil at higher prices. Once again, the speculators will be blamed for rising oil prices.

The other extension is that the world will be well supplied with oil due to inventory stockpiling. Spare oil available for storage implies the product is not demanded. When demand rises, those storing oil will supply the market. This, coupled with OPEC’s spare capacity, should keep oil at low levels for some time.

During the recent spike in oil, OPEC increased oil production to levels not seen since 2003. In fact, a casual look at the relationship of spare capacity to the price of oil reveals the price of oil falls as capacity rises.

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Prior to the ginormous price move from 2004 to 2008, OPEC’s spare capacity dropped precipitously. From April to August of 2004, spare capacity dropped from 2.29 to 0.71 million barrels per day. The average price of oil subsequently rose from $34b/bbl to over $130/bbl. Between July and November 2008, OPEC spare capacity surged from 1.22 million barrels per day to 2.54 million barrels per day, and oil dropped like a stone from $130/bbl to below $40/bbl, without a hint of resistance.

The bottom line - even if the global economy begins to expand (a huge assumption given recent data) there is plenty of oil in storage and in the ground to supply the market. It is unlikely that a new bull market in oil will begin any time soon.

Disclosures: None

Comments

[Tim Plaehn:]

Informative analysis. Thanks.

Jan 08 08:34 AM

[Clearlead:]

yet while USO goes down, the Oil stocks go up (e.g., HAL) ???? huh?

Jan 08 10:03 AM

[mc2406:]

Sounds like integrated oil company 4Q '09 or 1Q '10 earnings should be winners, so mid '09 stock prices should rise in anticipation?

Jan 08 12:05 PM

[Brian Kelly:]

I think HAL and other other oil service names have caught the same bid the market has in the last few weeks---i.e. anticipation of a 2nd half '09 economic recovery. That perception appears to be faltering and likely will take HAL with it.

There could be an argument made that since Brent is trading well above WTI, that there may be some incentive to drill for more Brent....but i think that is really a stretch.

On Jan 08 10:03 AM Clearlead wrote:

> yet while USO goes down, the Oil stocks go up (e.g., HAL) ???? huh?

Jan 08 01:15 PM

[Brian Kelly:]

Yes,
The integrated oils could do well in this environment - they have quite a few options for product now -- they can store it and play the contago or crack it into gas---the gas crack spread is back to positive after spending Oct-Dec in negative territory. Also those companies with retail outlets should benefit from low input prices and sticky retail prices - I know prices at the gas stations around me have not fallen as fast as oil and RBOB on the NYMEX.


On Jan 08 12:05 PM mc2406 wrote:

> Sounds like integrated oil company 4Q '09 or 1Q '10 earnings should
> be winners, so mid '09 stock prices should rise in anticipation?

Jan 08 01:21 PM

[mkreisel:]

Contango will slowly bleed USO to death.

If crude oil stays flat this year or next, USO will be another trap for retail investors, who rarely venture into the real world of futures trading.

Jan 08 01:36 PM

[blu:]

I'm with Pickens on this issue.
What we are seeing now is a temporary bulge in inventories that will soon be drawn down due to supply destruction.
We are still using over 84 million barrels of this stuff each day. Mexico, Ghawar, and the North Sea are all in serious decline. Just because they reduce production due to inventories does not mean depletion has gone away.
Oil is very cheap now, and I am buying.

Jan 08 01:37 PM

[Urbane Gori...:]

Based on that bottom chart, I'd say that it looks like OPEC hung themselves out to dry... Every time the price of oil spiked, they upped production. Every time they upped production, oil dropped. If they had been more judicious in balancing the supply with demand, then, maybe we'd be paying $80 for a barrel of oil right now and there never would have been that ugly spike and they wouldn't be worried about their negative cash flow.

Re: oil companies going up while oil goes down... It depends on the company. HAL is considered a 'construction company' and falls within the halo of the Obama 'promise'. Other companies are doing OK because the crack-spread is beneficial right now... (Haven't looked lately, but Valero?) and others have just been beaten to death and therefore are now considered 'value plays'.

jegan

Jan 08 08:30 PM

[Ferdinand E...:]

Very interesting article and comments, although I am curious about the expression 'negative cash flow'.

Jan 09 12:17 AM