What would happen if or when the oil storage capacity at Cushing, OK, now at 89% of theoretical limit, is filled to the brim? The facile answer is that it is negative for crude oil prices - when storage fills, there is pressure on those holding oil in storage to "dump inventory"; space shortage could cause a drop in prices especially in the front-end. Oil that can't be moved to where it needs to go quickly drops in price. A consequence would be front-dated contango in the WTI term structure steepening further - today's spot prices would be squeezed lower to pay for more expensive alternative options down the road. None of it is good news for oil producers already suffering from five quarters of falling oil prices. At least that's the gist of most analysts' take on the subject today - a "doom" scenario based on previous experience when similar capacity constraints occurred at the Cushing hub (e.g., 2012).
But not all analysts (including us) agree that this is the only, or even the most likely, scenario this time around. Conditions today are different from those other times, and even the causes of the build-up at Cushing this time around are not the same as those obtained during, say, 2012. Simply put, there may be some surprising responses from the oil market. For one, the market's response to full capacity described above may last for only a short time. Counter-intuitively, the initial response of the front spread to the dumping of inventory may subsequently lead to a flattening of the curve, as the inverse correlation of the spread to inventory reasserts (see chart above). Moreover, possible solutions to the issue of brimming tanks at Cushing may not necessarily come from developments at the capacity side, but could come from the output and arbitrage side.
Keeping oil in the ground as last resort
We believe that with prices already low, and in many cases, well below the threshold of operational profitability for some US oil producers, a last resort option will be to keep the oil in the ground. That is, capping the well. There is little doubt that as the spare space continues to fill up, cost of storage will skyrocket, making this simple solution even more appealing. The speed at which US shale oil producers can respond to a firming in prices is legendary - so they can also respond just as fast to the lack of storage space. Shale oil producers can quickly go back on-stream once storage conditions or the oil price become more favorable. Shut-ins will also contribute to a market recovery: output diminishes, which leads to higher oil prices, and subsequently (after a quarter lag), falling inventories, and much improved market tone. It is a beneficial feedback loop (see chart below).
There is an even starker reality which may overtake this issue of brimming oil tanks at the Cushing hub. It has been a year and a half since the price of crude oil declined precipitously, by 70% since June 2014. A cross-section of oil producers - small, medium, and some large ones - are faced with bankruptcy proceedings. Bloomberg reports Deloitte LLP as saying that "about 35 percent of listed pure-play companies which focus only on exploration and production (circa 175 producers), are at high risk of facing bankruptcy worldwide." This could surpass levels seen in the Great Recession of the 1930s. Law firm Haynes & Boone said that since the start of 2015, 48 North American oil and gas producers have declared bankruptcy, owing more than $17 billion.
Bankrupt oil producers may have no choice
If oil prices do not pick up "significantly" soon, the shut-in option that we discussed earlier could be forced on many oil players. Global investment banks are now collectively in an existential fight for survival due to loans extended to the energy sector that are going bad. So credit lines are being curtailed or being withdrawn, putting capex and opex at risk for many of these embattled producers. Capital expenditure in the global oil and gas sector is falling sharply, in cadence with the falling price of oil. If oil prices fall some more due to any reason at all, global capex will be cut further quickly (see chart below).
Ratcheting storage costs could well be the last straw that could lead to capping of wells, regardless of the obvious need for revenue for some operators to cover debt obligations. Not all operators would find this option practical, simply because closing down producing assets can often be quite costly, and in some cases (e.g. oil sands), the restart process can be extremely cumbersome and involve long lead times. That's why we are specifically focusing on shale oil operators as likely candidates for this particular option. We also exclude shale operators who hedged several years ago at much, much higher prices. There is no reason to shut in production if you have already sold forward at more than $80/bbl. There are reports that some of those hedges will not run out until the H2 2016.
Reasons why oil tanks are topping out at Cushing
It is also important to understand why tanks are threatening to top out at Cushing at this point. Hark back to our basic premise that the shale oil revolution was facilitated ("greased") by liquidity from the multiple Quantitative Easing (QE) programs launched by the Federal Reserve. With the US financial system flush with liquidity, banks were looking for a place to deploy it (see chart above), and they found it in master limited partnerships and independent drilling firms' intent on boosting oil and gas output quickly with fracking technology.
So intense was the banks' reach for yield that even as late as Q1 2015, when the oil price collapse was accelerating, the Financial Times reported that firms engaged in oil and gas exploration and development were able to raise more than $10 billion. The continuing infusion of bank credit (blue line in the chart above) had provided wherewithal for independent producers to continue drilling and fracking, even increasing production despite the sharp decline in oil prices.
The largesse from QE liquidity also enabled the construction of additional tanks which enlarged US capacity to hold oil, which also softened the sharp collapse in oil prices. Why so? There is empirical evidence and industry lore which show that inventory increased as oil prices fell, and as the US Dollar strengthened (see chart below). The availability of new storage has made possible higher stock builds because it could be very profitable to purchase and hold oil under current low oil market prices and the US Dollar's high purchasing power. However, as inventories continued to rise, the thought of more storage actually started to hinder price recovery, as the market ironically started to consider it as de facto spare capacity which would allow higher and further inventory builds.
How to mint money exploiting the "oil contango"
Investors can buy or import oil, store it, and sell contracts to deliver it at a higher price in six months or a year. This strategy becomes specially powerful when oil prices for delivery in the future are trading at a premium (higher) to those at the spot or the prompt market - a market term structure known as "contango". As it relates to the current situation, investors using this strategy are expecting prices to eventually recover from the 70 percent slide in oil in the past six quarters. There are a lot of incentives at present to get involved. The one-two months contango is quite steep (the first-month contract significantly lower than the next), and may steepen further, if the issues at Cushing are not resolved soon - all other fundamental issues (e.g., Russia-Saudi Arabia rapport) remaining unchanged. Based on historical correlations, that would tend to depress the WTI price, and increase the inventory build after a short lag (see chart below).
Moreover, the near zero-interest regime enables financing with cheaply borrowed money, and return on these transactions can be substantial even after deducting loan and storage costs. It has been said that there is essentially very little, even no risk, associated with storing WTI crude in Cushing, because the party holding the oil can deliver it under the futures contract and collect payment, if it is so desired. Or they close out existing contracts and sell new ones for future delivery of the same oil. The oil need not even move out of storage, if desired, and the strategy can be "rolled over" into other, new sets of futures obligations, if prospects for profit remain.
Stronger hands should go way up the oil term structure
Investors may also take a longer view of the oil market, believing for instance that after a 70 percent decline, oil prices would be higher several years down the road. A juxtaposition of the changes in the long-dated spreads with the changes in price and inventory (as controlling variable) can show clues as to the likelihood of success in using this strategy - we see from it the future tendencies in the evolution of oil price and inventory trends (see chart below).
The opportunities provided by the steep contango has helped push oil inventory to historic highs - and inventory is still rising (and could rise a little further) because it takes a while before changes in inventory catch up to the factors that helped build it up in the first place (at least a month's delay). However, the benign conditions that allow this money-minting strategy to prosper will, at some point, turn around. It may even be doing it now: oil prices are starting to firm, the US Dollar is weakening, and the capacity market is tightening, driving storage costs higher. But conditions are still benign, as reflected in the current oil term structure - there is still a steep contango in the WTI one-two spread (see chart below).
Cushing storage issues create a buzz, but it is purely local
This brings us back to our basic argument that Cushing storage issues are local WTI phenomena, and are more pertinent to the WTI structure rather than to general oil pricing dynamics, although second-order consequences of lower storage space can feed back to impact oil prices lower. A second order consequence of crimped Cushing storage comes in the form of short dated contango which will likely steepen further. Another suggests that the physical (spot) difference (spread) between Brent and WTI should widen in favor of Brent, and the coming spring maintenance in the US will likely help widen that spread further, as typically, refinery maintenance should result in further build in crude oil storage levels. With the current level of storage, particularly at the Cushing hub, the impact on the physical differentials could be substantial - the spread could go back to levels seen during the past two years (see chart below).
US-wide, oil storage capacity remains ample
It is inaccurate to characterize that the storage capacity in the US, as a whole, is filling up fast, whatever may be the conditions at the Cushing hub. Despite record stockpiles, the US still has probably 200 mb of space available, after inventories have been adjusted for pipeline fill and for crude in transit. The USGC alone is said to have perhaps 125 mb spare capacity left. Even assuming 20% of this available space is inaccessible because it is needed for blending and tank bottoms (see chart below), it is likely that the Gulf Coast still has some 100 mb space left .
Note that this available space need not be exactly at the Cushing hub, but these are indeed viable storage options, given the flexibility of the so-called "Cushing complex". As Morgan Stanley's Evan Calio described, the storage hub at Cushing has changed significantly in recent years. It used to be that Cushing's tanks were land-locked - pipelines ran from the Gulf Coast to Cushing, which largely relied on mid-continent refineries to drain the tanks. But with the construction of big pipelines like the Seaway, Seaway Twin and TransCanada line, the process can be reversed to evacuate more than 1.5 mm bpd more out of Cushing hub, down to the even bigger storage tanks surrounding the Gulf Coast refining megaplex. There were even additional capacity that were developed to allow crude oil to bypass Cushing.
Full storage at Cushing may never be realized
Interconnectivity among these storage complexes has tremendously improved in the past 5 years, to a point where full storage at the Cushing hub may never be realized. There are several inter-meshed reasons for this. One significant reason is that regional differentials move as congestion builds, allowing access to alternative storage, markets and clearing mechanisms. There are big arbitrage opportunities in that situation, with the underlying theme being "buy oil low in Cushing, and sell it high to refineries along the Gulf Coast". It used to be that the issue with this strategy was how to get the oil from Cushing to the Gulf Of Mexico (NYSE:GOM) - now, it can be done with reasonable costs and fairly quickly. If the price differential between WTI and Gulf Coast light, a crude known as Louisiana Light Sweet, widens any further, then the migration of oil stock from Cushing to the GOM may indeed accelerate (see chart below).
Refinery input synonymous to inventory does not hold anymore
Another: refineries will simply "chew up" the inventory glut, by running their plants at faster rates. They are incentivized to do so by refining margins that for some discounted crudes, widen in cadence with further fall in oil prices. In fact, the fear of tanks topping out at Cushing had been stoked by scheduled refinery maintenance during this coming spring. However, we invoke this option with some caution. It used to be that the inventory builds were significantly accounted for by refinery input requirements, but that changed in 2008, the year the Fed started QE. Since then, the surfeit of systemic liquidity provided by a series of QEs, which capitalized new storage and paper (futures, ETFs, derivatives) oil assets, markedly changed the relationship between the two variables. Now, changes in refinery inputs retain only a vague, badly defined correlation with changes in inventories (see chart below). Henceforth, we should be careful in making positive, linear extrapolations of the relationship between expected refinery inputs and future oil inventory builds.
Exporting oil is serious contender to end the Cushing glut
Finally, exports could also be one low cost option in a cost curve of differentials. We do not doubt that if the Cushing situation gets even worse, US exporters of oil have plenty of incentives to ratchet up their tempo. Note that we are ignoring the actual costs, hedging costs, and cost differentials of shuffling all that oil into or out of Cushing, which if internalized, could further steepen the contango. But it is clear that if the Brent-WTI physical spread continues to widen, then exporting WTI oil, which has been picking up momentum for some time, becomes a serious contender in easing the glut at Cushing. US crude oil exports have been rising since the WTI-Brent spread hit bottom at $-27.9 in September 2011 (see chart below).
Big-time operators are getting set to export oil originating from Cushing, which could alleviate the biggest ever build-up of surplus oil supply. Vitol is set to send out export cargoes of oil, reportedly encouraged by the March-April spread of circa $3, the widest in years, according to Reuters. More details of that story here. Oil originating in Cushing is now also at discount to other crudes located closer to the Gulf, such as Eagle Ford or Midland crude and could encourage regional arbs as well. The export venue will play a big role in reducing the pressure on capacity at Cushing, as the arbitrage window will likely stay open for some time and may even widen.
This flexibility for the Cushing complex, and many of the alternative options, were non-existent in 2012, when Cushing reached its then record fill of 88%. But the situation then and now are not directly comparable, hence we should look at these events as distinct from each other. For one, there was a big difference between now and then in price. WTI oil price is now at low $30s; back then, it was $100. Well shut-ins could be considered a valid option as response to the lack of storage space today; it would have been unthinkable back in 2012.
The global storage condition remains benign
The global storage space condition is also still benign. Macquarie said that as from early January, there may still be 500 million barrels of remaining capacity. Moreover, storage levels are likely significantly higher than implied above, as non-OECD storage levels are not directly tracked by the IEA. A significant amount of excess storage capacity is likely held in developing SPRs, notably in China and India, which may not be directly available to the market even when supply/demand balances had improved. Although excess crude supply beyond global demand has resulted in seasonally abnormal inventory builds, global crude stocks will not likely reach full capacity even if crude inventory levels continue to increase through 1H 2016.
Improving global market balance may also do its part in alleviating the storage issue, Macquarie said. By the end of 3Q 2016, the crude market should return to seasonally normal balances, with draws anticipated for 3Q 2016 and 4Q 2016, which should begin to lessen the pressure of high inventory levels globally. There are more details of this subject at my Seeking Alpha blog, especially at the discussion part, if anyone is interested (read the blog entry here).
Projecting oil turning points using simple constructs
Here is one reason which tells us that a global oil market rebalancing is nigh. In the chart above, we show a set of simple global oil balance measures where we juxtaposed the delta of the change rates of global oil demand and global oil supply, along with the ratio of the changes in global oil supply and global oil inventory. The basic premise was that these constructs should be able to provide advance information as to likely turning points in the oil price. Our explicit assumption: the tipping points in the demand-supply and supply-inventory dynamics will appear ahead of the turning points of the nominal oil price, or even the inflection points of the oil price's change rate. As it turned out, those simple constructs may have performed what we hoped for - the lead is shown to be as long as 4 quarters ahead. The information indeed provides valuable guidelines when we do the traditional spreadsheet work on oil global supply and demand dynamics. The spreadsheet work validates its numerical counterpart.
So by the end of 3Q 2016, we may have already forgotten this buzz about brimming oil tanks in Cushing, in an energy world with a more benign scenario of stable or even firmer oil prices, and a WTI one-two spread that is making its transition from steep contango to slight backwardation. At that near-future time, crude oil inventory should have peaked, responding to the earlier impact of higher oil price, an even weaker US Dollar, and the disappearance of the WTI contango (see chart below). At least that's what we hope for.
We can hardly see indications of that near-future, benevolent scenario today, as the market remains in a very explosive trade-off - how much crude builds off run - cuts and/or refinery maintenance versus how much supply is being destroyed. Oil price momentum seems all the rage - the market is predominantly short and uni-directionally betting to the downside. Nonetheless, the rebalancing process is already underway as we said. With oil prices in the $30s, many producers in the world were losing money and for some, prices were already below cash costs. The recent WTI price decline below the $30s added more pain, further pushing below the cash cost of even more producers.
However, we are seeing a faint light at the end of the tunnel - even oil uber-bear Goldman Sachs now acknowledges that "most of the negative impacts from declining oil prices are likely behind us at this point. The obvious being that oil prices don't have much further to materially fall", saying further that "the market will not anymore be surprised by spikes to the downside into the 'teens'...(which) is now a consensus view, with the market positioned as such." So oil prices could still go somewhat lower from here according the Big Uber Bear, a scenario that we can live with, until the end of the first quarter.
We will never know the reasons for GS changing their tune. There are developments in the supply-side arena, true, but we'll never know for sure. Regardless, we firmly believe that the lower prices go from here, the higher they will rebound in the future as current low prices are resulting in large investment cuts that will eventually feed into supplies. To us, that skews the longer-dated risk to the upside. Moreover, relief could come by late 2Q - early Q3 2016, a scenario that the long-dated oil term structures and our simple global oil balance measures seem to be signaling.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.