Musings: Do WTI Oil Prices Reflect Underlying Market Conditions?
On December 23, crude oil prices flirted with $30. That barrier marked the bottom of the price decline that commenced in early July after oil futures hit $147. The $117 price decline has done much to alter the current and prospective landscape for the oil and gas industry and the global economy, too. Just when it seemed oil prices were headed toward zero, a wave of optimism swept over the crude oil trading pits after Christmas and prices rallied through the start of 2009 heading back toward $50. During the early days of the first full week of January, crude oil futures prices actually traded above $50 during the day, but failed to hold on to that level on the close. Having run up by almost $20 a barrel, it was not surprising that traders began taking profits since the $50 price -- viewed as a critical technical trading support level -- hadn't held. At the same time, increasingly disappointing economic figures were being released showing further significant deterioration in the health of the U.S. economy and other major economies around the world.
The reversal in crude oil prices reversed what had become a new bull market for crude oil into another bear market. The question for which both commodity traders and energy stock investors are seeking an answer to: What will be the catalyst to end the bear market and reignite another oil bull market? (That is an important driver for energy stock prices.) A better economic outlook would be one condition, but possibly a view that the stimulus being injected into economies around the world will eventually bring a surge in inflation, which often boosts commodity prices.
Along with the worse than expected economic statistics released over the past few weeks came a strengthening of the U.S. dollar,
which tends to depress crude oil prices. The increasing economic problems in Europe and Japan, and now China and India, has prompted a flight of capital to U.S. government bonds further helping to boost the value of the U.S. dollar. Probably more challenging for the near-term direction for oil prices is the growing volume of crude oil being produced and not consumed. OPEC’s several attempts to reign in its members’ production flow last year have only recently begun to have an impact on the available supply of oil globally, but in the interim large quantities of oil were arriving at markets that do not need it. Some large oil companies and crude oil trading firms have contracted a handful of very large crude carriers (VLCCs) to store oil. They saw that future oil prices were sufficiently high and the opportunity for oil buyers to purchase current volumes and sell contracts to deliver the oil at some future date and make a profit even after paying the storage fees.
The volume of oil stored in tankers has climbed to 80 million barrels, based on 40 VLCCs each holding roughly two million barrels of oil. According to Frontline (FRO-NYSE), the world’s largest operator of VLCCs, the current rate to charter these tankers is about $75,000 a day. That translates into about $1.12 a barrel per month for storage. As long as a buyer of crude oil can cover this cost for storing the oil, he will engage in these time-spread trades. The contango condition (future crude oil prices being substantially higher than current prices) that exists in the crude oil market today as it relates to West Texas Intermediate (WTI) oil has begun to raise questions of whether the price for this crude actually reflects the oil market's underlying fundamentals, or rather is a victim of a regional market imbalance between supply and demand.
One of the manifestations of weak WTI oil market fundamentals is the continuing build in oil inventories despite the relentless drop in price. Last week, the Energy Information Administration (EIA) reported that for the week ending January 9, crude oil inventories, excluding oil in the strategic petroleum reserve, increased by 1.2 million barrels. This pushed total inventories to 326.6 million barrels, above the upper limit of the historical average volume of inventory at this time of the year. More important was that inventories continued to climb at Cushing, Oklahoma, where WTI is traded and the global oil price established. Cushing’s inventories increased by 800,000 barrels bringing storage to 33 million barrels, which is rapidly approaching the maximum operable storage capacity (34 million barrels) based on the assumption that 80% of the 42.2 million barrels of total capacity is available as working storage.
The impact of rising Cushing inventories has been to depress current spot oil prices because WTI oil is landlocked. The spread between WTI and other popular crude oils has widened to an extreme seldom seen. Since WTI has limited access to waterborne oil markets that could relieve its inventory challenge, it has recently traded at substantial discounts to other domestic crude oils in the physical oil market. Last Wednesday, WTI traded in the physical market in Houston at a 15¢ per barrel discount to the Mars blend (the representative crude oil produced in the Gulf of Mexico) when it normally sells at a $4-$5 per barrel premium.
What has further demonstrated the recent distortion of the WTI oil market has been the relationship between WTI and the North Sea’s Brent oil, the most frequently traded barrel in the European crude oil market. In recent days, the spread between WTI and Brent has soared to unusually high premiums. Traditionally, Brent, a lower quality crude oil compared to WTI, sells at a discount of $1.50 a barrel, but in recent days has seen that morph into a premium that widened to about $10 a barrel. Throughout history, WTI and Brent
have essentially tracked each other so closely that it appears they are one and the same on any long-term price chart.
On the other hand, over the past two weeks, as the storage volumes at Cushing have approached capacity, the WTI premium over Brent has fallen to a substantial discount. Notice the upturn of the Brent price line (in red) compared to WTI in recent weeks. To show the dynamics of these markets, especially in recent days, we plotted the spread between WTI and Brent over the time period. Since summer the premium for WTI has been running about $5, except for the one day in late September when WTI spiked due to a short-squeeze in the commodities trading market. Over the past almost 13 months, Brent has largely traded at a discount to WTI, which can be seen by the gap between the two price lines on the chart in Exhibit 4.
Another characteristic of the crude oil market this year has been the daily volatility. Oil prices change by 5% or more 39 times in 2008, one more than the number of days it happened in 1990.
We were curious about the nature of the oil markets when there was this huge increase in price volatility. We plotted the daily price changes in the crude oil futures prices for 1990 and 2008. What we found was that when oil prices entered a dynamic state price volatility increased. We surmise that this is related to the uncertainty about the strength and stability of the trends moving the oil price. This has a tendency of attracting traders and speculators that boosts the trading volatility. But it is clear that in 1990 when oil prices were steady, volatility was less than when the oil price was moving either higher or lower.
In 2008, the volatility in the crude oil market seemed to be associated with the change in the health of the credit market, i.e., volatility picked up around the time of the failure of Lehman Brothers and the sale of Merrill Lynch, and when credit market turmoil impacted hedge funds and the credit markets. In other words, the trading volatility seems to be more associated with broad financial market events and less with crude oil market fundamentals.
This price action suggests one of three courses of action will evolve. One is that Cushing inventories reach their maximum capacity so WTI prices plummet to the point at which refiners will buy the oil to produce product because almost whatever product prices are they will make a positive spread. Second, domestic consumption rebounds causing a jump in crude oil purchases, or third, the OPEC production cuts reduce supply sufficiently and less oil flows into the U.S. leaving greater room for WTI oil to supply normal, albeit lower, demand. We suspect that before anyone of these courses of action develops, it may be some weeks into the new year. That suggests there is great risk that WTI crude oil prices could fall into the $20s a barrel range. But the important thing is that the WTI price will not be reflecting an accurate reading of the underlying supply and demand trends in the global oil market.
The uncertainty about the health of the economy and the oil market is also demonstrated by events happening in the petroleum product market. Last week saw the government report that 6.4 million barrels of distillate including heating oil was added to inventories. Analysts are offering two possible explanations. One is that it reflects weak consumer demand, a reading of the health of the U.S. economy. The other conclusion is that refiners are boosting production of heating oil fearing more cold weather. We believe this conclusion more than the first for the reason that people can die from a lack of heating oil, as opposed to a lack of cooling during extreme heat waves in the summer. The economic hardships being experienced in the country today should be a governing principle. Public sentiment and political retaliation against companies that allowed citizens to die during a period of extreme cold due to a shortage of heating oil, just after oil prices have fallen by $100 a barrel and the world is swimming in crude oil, would be extreme. This is not a position oil industry executives want to be in given the low esteem they are already held in by the public.
Just how bad is the global oil market? In reality, the latest forecast by the International Energy Agency (IEA) cut its estimate of 2008 and 2009 oil demand are merely catching up with the prior dour forecasts by the EIA and OPEC. The IEA cut its estimate of 2008’s global oil demand growth to a decline of 300,000 barrels per day (b/d). It has reduced its demand forecast for 2009 by 950,000 b/d producing an estimate that demand will fall by 500,000 b/d from 2008. The IEA is now firmly in the camp of successive yearly oil demand contractions for the first time since 1982 and 1983. Our only concern is that the IEA’s forecasting record in recent years has
always been too optimistic. Time will tell.
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