In an ominous sign of supply and demand fundamentals in the crude oil market, the West Texas Intermediate (WTI) May 2020 contract closed on April 20, one day before its expiration, in negative territory, finishing the trading session at minus $36 per barrel. As contract holders tried to roll their position into the following month, the price continued to dive into negative territory. The weeks preceding the crash saw a record inflow of retail investment into several large crude oil exchange-traded funds. This drove open interest in the May futures contract to over 600,000 contracts, equivalent to 600 million barrels. As expiry for the May contract approached, large investors sold out of the May contracts and transferred their position to the contracts for delivery in future months (known as “rolling futures” in industry parlance), leaving under 200,000 contracts of open interest in the May contract. The day before the expiry date, the physical bid quickly evaporated, as buyers were hesitant to own the contract at expiry, fearing they would be forced and unable to take physical delivery in a market without immediately available storage capacity. As financial holders fled, the contract was left subject to the forces of pure physical supply and demand – and there was virtually no demand.
In environments where there are more modest differences between supply and demand, storage acts as a balancing mechanism between physical and financial markets by providing an outlet for excess supply when demand softens. What’s more, the terms of the WTI contract include a mechanism for physical settlement at Cushing, Oklahoma. When a near-term futures contract expires and its open interest “rolls” to the following month’s contract, traders who do not liquidate the contract before expiring must take physical delivery over the course of the month. The availability of storage acts as a balancing mechanism that links and brings equilibrium to physical commodity markets and their corresponding financial derivatives by allowing traders to take physical delivery of oil, theoretically leading to a convergence between futures and physical prices at contract expiry. Physical traders with the ability to take delivery of and store crude oil should have incentive to step in to buy close-to-expiry futures (at a small discount) from financial holders, earning a slight margin on the discount at which they buy the crude before taking delivery. This incentive could be heightened by the presence of a contango structure in the market, meaning the trader could take physical delivery over the month, pay storage, financing and insurance costs for a period of time, sell future-month contracts and still earn a margin. On April 20, the combination of a large open interest one day before expiry, the difficulty of securing storage at Cushing, which was filling open and largely “spoken for” under term contracts, and an extremely bleak demand picture led to a marketplace with many sellers and very few buyers, resulting in prices hitting negative territory.
When storage capacity is restricted – and with it, the ability to take delivery of crude oil against the futures contract – the stage is set for significant volatility at contract expiry. While Energy Information Administration (EIA) data reported the crude oil tank farm at Cushing was roughly 81% full on April 24, practically speaking, all of the remaining storage capacity in May has been leased by physical midstream or trading companies. Crude stored at Cushing on April 24 totaled approximately 61.2 million barrels, up nearly 80% since the start of 2020 and now rapidly approaching total storage capacity of 76 million barrels. The rate of storage growth at Cushing has been magnified relative to national growth in stocks due to its status as the physical delivery location for the WTI contract.
With Cushing filling up and close to full, and traders using alternative storage in creative ways (think tankers, truck trailers and perhaps even idled cruise ships), the potential for continued price volatility remains high, absent a near-term rebound in demand. And without adequate storage capacity as a balancing mechanism, the WTI price may continue to be particularly volatile, although the exchange has taken measures to limit the role of financial speculators in contracts close to expiry. If liquidity suffers in the WTI contract due to storage capacity issues, prices could continue exhibiting significant volatility; the contract may over time serve less of a role as a basis for physical contracts between producers, traders and refineries. Time will tell.
While the contract’s predominance may be affected over time, for those with storage assets using futures to hedge, WTI can be an effective – and very profitable – hedging tool in the right market environment. Having storage capacity at Cushing in this environment has proven to be quite attractive for traders and midstream businesses. The cash-and-carry trade is one that relies on the structure of the futures market, where contracts for delivery in sequential months reflect increasingly higher values. This term structure means traders can profit when placing physical barrels into storage and hedging in future months, generating a return that exceeds the cost of carry – or the sum of storage, insurance and financing costs. Those with storage rates agreed to before the crisis, low-cost financing options and established insurance polices have been best positioned to benefit.
For storage operators, the rush for storage creates a sudden surge in demand for the commodity to sell: energy storage capacity. On April 17, the 12-month difference between physical and future pricing exceeded $17 per barrel. One only needs to look at LOOP Crude Oil Storage Futures, which have increased in value by over 500% during the past week, to see the scarcity of storage quantified. The cost of leasing 100,000 barrels of crude oil storage for one month in the Louisiana Offshore Oil Port (LOOP) was roughly $7,000 before April 20; that cost has now risen to approximately $55,000.
While most available crude storage has been spoken for, if a trader was able to secure a one-year lease for an 80,000-barrel tank at the LOOP, storage costs would be roughly 55 cents per barrel per month – or $528,000 for a one-year period.
If a trader using debt leverage of 5-to-1 bought, stored, hedged and ultimately exited its crude position in one year by unwinding its futures hedge, the trader would stand to generate a roughly 246% economic return on capital after factoring in storage costs, 5% interest and a 20% cost of equity. Commodity lenders are currently receiving many inbound queries per week regarding storage financing.
In a stark reflection of demand destruction brought about by COVID-19, net crude imports and domestic refinery crude inputs have each fallen by roughly 20% in the past six weeks. Looking toward supply, while the number of rigs drilling for new crude oil production is down approximately 41% over the same time period, shut-ins of existing production come only as a last resort. Since the start of March, EIA data shows crude oil field production to be down only 7% – domestic crude supply has responded too slowly to prevent inventory builds, so the price is now forcing supply to shut in. While the outlook for the crude oil market is gloomy in the face of global pandemic, the prospects for owners of tank farms and those with access to them are bright. As the saying goes, the best cure for low prices is low prices. And for now – low prices may be the only cure.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03583-2020-04-30