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Ahead of the curve: Crude Oil in unchartered territory

May 4, 2020

A commentary by Jürgen Lukasser, Chief Investment Office of LGT Bank Österreich, on the low oil price and whether a deep recession and a collapsing demand for crude oil can be expected as a result of the economic situation. 

Ahead of the curve: Crude Oil in unchartered territory

The current situation on the crude oil market is characterized by a range of unfavourable factors. The beginning was marked by a coincidence of the corona virus and the failed OPEC+ negotiations. The initial restrictions in Asia, followed by Europe and finally in the USA appear to be the only effective means to get the infection rates under control. At the same time, these measures led to the outbreak of a global recession, with air traffic coming to a complete standstill in many parts of the world. At the same time, the OPEC+ negotiations scheduled for the beginning of March (i.e. OPEC states plus Russia) did not produce any results. The result was a price war. The pandemic-related decline in demand for crude oil, combined with the price war mentioned above, led to a clear supply overhang. This resulted in a price drop from USD 60 per barrel to around USD 20 per barrel within a few weeks. This is also already a severe correction, but was comparable in speed and extent to the corrections in 2008 and 2014. In the end, the 2020 correction did lead to an agreement within the OPEC+ negotiations: on 12 April, a cut in production of 10 million barrels per day was agreed. This is roughly equivalent to Russia's daily oil production and is the largest production cut in history. This was intended to stabilize the oil price. How could this nevertheless lead to a massive drop in prices?

At this point, the role of the futures markets for crude oil should be considered. Futures for West Texas Intermediate crude oil are traded in New York on NYMEX (New York Mercantile Exchange). Essential for understanding how these markets work is the way these contracts are settled: the holder of a so called "long position" receives 1000 barrels of crude oil physically delivered on the maturity date. The place of delivery is determined in advance: Cushing, Oklahoma.

In this context, it is crucial that the warehouses in Cushing and the surrounding area are completely filled due to the low oil price in recent weeks and therefore there is practically no free capacity available. Potential buyers who try to take advantage of the low oil price are therefore having difficulty in finding adequate storage space.

Who are the largest investors in long positions in oil futures? The answer is ETFs and ETCs (Exchange Traded Commodities), which track the development of the oil price. According to their regulations, these ETFs and ETCs are not allowed to hold physical stocks in crude oil. They are therefore forced to sell the futures positions in good time before expiration in order to avoid being held liable for the delivery of physical oil. The most liquid trading in commodity futures takes place almost exclusively in the next three maturities. As of 20.4.2020, this is the future with maturities of May, June and July. Essential in this context is the May contract, currently the so-called "front contract" (i.e. the one with the shortest remaining term), since the last trading day is 21.4.2020. ETFs and ETCs that are not allowed to hold physical oil positions according to their regulations must therefore sell on 20.4. or 21.4. Under normal circumstances, an arbitrage mechanism will be used if price corrections are excessive. Commodity traders, who are allowed to hold physical oil positions in the oil tank, buy the futures at low and therefore attractive prices, accept the physical oil delivery and then sell the physical oil stocks. However, this arbitrage mechanism does not currently work, as there is no storage bin available. ETFs and ETCs that urgently need to sell up to and including tomorrow do not meet demand. This can explain the massive drop in oil prices to a negative level.

 

Jürgen Lukasser's assessment:

Are we therefore entering golden times for drivers who are paid money at the gas station when they fill up their tank? Unfortunately, this is not to be expected. A look at the so-called "term structure" of the futures market for crude oil provides important information.

 

WTI Future May 2020 -25.00

WTI Future Jun 2020 20,95

WTI Future Jul 2020 26,78

WTI Future Aug 2020 28.94

WTI Future Sep 2020 30.25

 

The futures market for crude oil currently sees the price in June already back at +20.95 USD and as of September at +30.25 USD. The curve of forward prices thus rises relatively steeply upwards ("the market trades contango") and actually prices in a relatively significant economic recovery in the second half of the year. The unpleasant news for potential oil investors is therefore that only those who currently have an empty tank in Cushing, Oklahoma can benefit from the caprices in the oil price. The lack of arbitrage trading offers truly unique returns here. All other strategies make no sense from today's perspective, unless you believe in a strong, V-shaped recovery of the economy and thus overall (above USD 30) rising oil prices.

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