Oil's contango-ious troubles
Edition 10. No one wants to hold oil. Why Marxism might explain Buzzfeed.
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Now, let’s get into today’s post.
20th April marked a cataclysmic day in the history of commodity trading.
The price of oil turned negative!
Or did it?
More accurately, as Matt Levine put it
The price of physically settled front-month West Texas Intermediate oil futures is negative.
Let’s deconstruct the sentence. The implications of this matter relate to not just the prices at the gas station for commuters but also to geopolitics and survival for millions.
WTF is WTI?
Oil is considered an asset class like gold, or equities, attracting a lot of people who wish to invest in it in the pursuit of profits. Unlike equities which are paper-based (and now digital certificates), oil is a voluminous oozy commodity. These investors do not actually want to possess the commodity. Futures gives them a way to invest without the hassle of owning the commodity.
From Matt Levine
You buy a financial instrument that goes up if the price of oil goes up and goes down if the price of oil goes down. That’s what you want, a bet on oil prices without the inconvenience of owning a lake of flammable liquid.
It would be nice if there were just, exactly, that thing. “Permanent abstract oil,” you buy it for the price of oil today and sell it for the price of oil when you want to sell it. But there isn’t. There are oil futures: You buy abstract oil today and it converts into real oil in May, or whenever. You do not want real oil, in May, or ever. Perhaps your bet is just “the price of oil will go up by the end of April.” Then you buy May futures today, sell them by the end of April, collect your profit (or loss) on the bet, and never get any real oil. (The futures you buy and the ones you sell offset; no one delivers you any oil, and you never deliver anyone any oil.)
But more likely your bet is just “the price of oil will go up sometime.” (Just like buying a share of stock is a bet that its price will go up sometime: You are not locked into any time frame.) You do not actually want the May futures, exactly; you just want abstract oil. So what you do is you buy the May futures, to bet on the price of oil without owning actual flammable oil, and then as the expiration date of the May futures gets close you sell those futures and buy the June ones instead. (This is called “rolling” the futures.) As the June expiration approaches, you do it again. You keep owning oil-but-not-quite-yet, giving you exposure to oil prices without the inconvenience of actual oil.
West Texas Intermediate (WTI) is the benchmark used for the futures trading in the US. The major trading hub of this index is in Cushing, Oklahoma. At the expiry of the oil contracts, one needs to take physical possession of oil here.
So, where exactly is this place?
As a result of this quirk, there are large scale storages in Cushing allowing traders or refiners to take supplies and store them as required.
The other major benchmark for oil futures is Brent crude which is drilled in the oil rigs of the North Sea, off the coast of the UK. On 20th April when the price of WTI crude future hit - $40/barrel, the Brent crude futures was over $20/barrel. Moreover, even the June and July prices for WTI futures were over $12/barrel.
This situation—in which the price of the June contract is far above that of the May one—apparently delights in the name “super contango.” People put a price on oil—they think it has value and want to own it at that value—but they also put a price on not having it now, and the latter price is quite high relative to the former.
So why did the WTI futures in May turn negative?
The demand for oil has collapsed. With no cars to drive, factories shuttered, and planes parked at the bay, the global demand for oil is expected to sink by 29 million barrels a day - a third of global supply.
Global storage for oil is ~4.4 billion barrels, including land and water (in large containers). As of the third week of April, 65% of the total storage is occupied. 10 million barrels are being added to this every day thus ensuring that the total capacity is on track to be filled in less than 100 days.
This footage of the US coast guard of an unprecedented number of oil tankers parked off the coast of Southern California shows how rapidly the barrels are piling up.
It was estimated that on 20th April, storage in Cushing was already 70% full with the remaining contracted to traders and operators. The lack of storage, massive glut and cratering demand made traders desperate to sell off their WTI futures to avoid getting stuck with physical barrels of oil. In fact, they were so desperate that they were willing to pay buyers to take over their stocks. This led to the historic tumble which flashed across the news screens.
Interestingly, Brent crude futures stayed positive and are currently trading higher than WTI futures for June and July. Why?
Again, a quirk of how they are traded. Brent crude futures are settled in cash which means that at the expiry of futures contracts, the trader simply has to settle the difference in the future price and the spot price (actual going rate of the oil). It also relies on storage in large containers at sea which is relatively more plentiful even though those are filling up quickly too. But for now, their advantage has held.
What is the impact of this?
Oil has shaped much of the geopolitics of the 20th century and just like that, the era seems to be rapidly getting over with profound implications for the major producers.
In Saudi Arabia, oil revenues account for 60% of the country’s GDP, and two-thirds of the government’s budget. In other states in the already-turbulent Middle East, including Iran, Iraq, Qatar, and Kuwait, the dependency is greater still. In Russia, petroleum accounts for one-third of GDP and half of the budget.
How does the world of extremely low oil prices for countries where oil revenues are responsible for the legitimacy of the government and their geopolitical influence play out? It is clear that the status-quo will not sustain and rapid changes will need to be made. Saudi Arabia’s Vision 2030 which lays a roadmap to make it a tech-hotbed and diversify its economy away from oil, is a case in point.
Worse still is the condition of smaller producers like Nigeria, Libya, Venezuela and South Sudan where oil finances almost all of the government budgets.
Take South Sudan for example. Oil contributes to 95% of government revenues. In 2017, the UN declared an unprecedented famine in the country stating that over 100,000 people faced death by starvation and a million more were on the brink. The coronavirus pandemic has resurfaced that threat making the country vulnerable. Experts are warning of a famine of biblical proportions across Africa and South Sudan in particular. A similar fate of destitution awaits civil strife-torn Libya and autocrat led Venezuela.
Institutions like the IMF and other UN agencies are stepping up efforts to avoid an economic and humanitarian disaster.
One bright spot amidst the gloom is that renewable energy prices seem to have decoupled with oil prices. Typically low oil prices are a curse to renewable energy. However, this time it might be different.
What’s different this time is that the cost of renewables and natural gas has broken away from oil, weakening crude’s influence on the price of electricity. While the coronavirus has destroyed demand for oil and transport fuels, power use has dropped less sharply. And importantly, energy companies are now painfully aware of the mounting pressure from consumers -- and investors -- to clean up their output, rein in emissions and prepare for a future beyond oil.
A future that green warriors have long dreamed of, may get accelerated as oil goes slowly but surely into the sunset.
In other news
Here is a roundup of a few interesting things that I came across this week.
Buzzfeed’s founder used to write Marxist theory and it explains Buzzfeed perfectly.
The key insight is that cultural identities are being scrambled by late capitalism and people want to root themselves in one. Notice the cult around bonding over new tv shows or figuring out which Harry Potter character are you? I know, pretty cool.
This rather absorbing twitch channel of a bike messenger who livestreams biking across NYC every day. A very unique perspective and you see the traffic slowly but surely increasing day after day.
The Social distancing project where users submit the mundane and insane stories of the lockdown to this Instagram handle. Yes, we are in this together
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