Bottom picking oil prices is a dangerous business
Head of Commodity Strategy
Summary: Crude oil remains anchored near an 18-year low as the market has entered a period of unprecedented demand destruction. With these very low oil prices we have also seen buying of oil from investors and traders who normally dont participate in the market. In this article we will highlight the reasons why such a strategy could easily end up costing money, even if prices stabilize and start to recover. We also take a look at alternative ways of getting involved.
What is our trading focus?
OILUKJUN20 – Brent Crude Oil
OILUSMAY20 – WTI Crude Oil
XOP:arcx – Oil & Gas Exploration & Production
XLE:arcx – Energy Select Sector SPDR Fund (Large-cap US energy stocks)
Crude oil remains anchored near an 18-year low as the market has entered a period of unprecedented demand destruction. Numbers vary but daily consumption look set to collapse by around 20 million barrels/day this month and beyond. This in response to an almost global lock down which has left people in their homes and planes grounded on the tarmac. Additional pressure is being applied by rising production from Saudi Arabia, Russia and others following the March 31 termination of the OPEC+ deal to curb production.
Volatility remains extreme with the 14-day Average True Range showing that a daily trading range of $3.6/b or around 18% can be expected. With prices so low the market clearly expects to see some producers go to the wall. Something that will remove supply in the short-term and potentially pave the way for a strong recovery once demand starts to recover.
With this in mind, we have seen buying of oil from investors and traders who normally don’t participate in the oil market. In this article, we will highlight the reasons why such a strategy could easily end up costing money, even if prices stabilize and start to recover.
The table below highlights the kind of damage that has been inflicted on the price of oil and countries and companies operating in the sector since January 17 when the coronavirus became a worry outside China.
The dreaded contango
Our readers have probably heard stories about oil traders once again making a lot of money from buying crude oil in the spot market, store it for a few months, and then sell it back into the market at a higher price. This so-called contango structure is reflecting an oversupplied market where lack of demand has left the spot price the cheapest on the curve.
At the same time, the expected fallout in terms of production being removed may pave the way for another oil shock to the upside in a few years’ time. These opposing ideas are currently keeping the forward curve very steep. And while those who have access to storing unwanted oil for future delivery can make a lot of money, an investor buying crude oil, whether it is a future, CFD or an ETF will all be facing the opposite challenge.
Using Brent crude as an example. The June contract (LCOM0 or OILUKJUN20) is currently trading 13.8% below the July, 24% below August and 32% below the September contract. In order to make any return on a long crude oil position, these are the hurdles a buyer will face. Alternative a trader could consider buying further out, ex. the December contract. By then however, the price needs to be 44% higher for the trade to work out. Before that happens the risk is that the price will drift lower towards current spot levels.
With the short term outlook pointing to lower prices in order to force production shut-ins we urge potential investors to be patient. A better alternative could be looking at strong oil and well-capitalized oil companies that can withstand the current pressure to emerge stronger on the other side. Our equity strategist Peter Garnry earlier this week published an update where he showed a list of energy sector companies with the highest and lowest implied default rate. An alternative to single stocks could be ETFs tracking the US or European oil and gas industry.
No doubt that a lot of damage is already being inflicted on producers around the world. Not least high-cost producers in the US who rely on an increasingly congested pipeline system to ship its oil to refineries, storage facilities or export terminals. With WTI crude oil at $20/b as the reference price we find very low prices at these important production areas:
West Canada Select: $5/bbl
Bakken, North Dakota: $9/bbl
Permian, Midland: $14/bbl
LLS, Gulf Coast: $15/bbl
Later today at 14:30 GMT the US Energy Information Administration will release its weekly stock report. The American Petroleum Institute in their report yesterday highlighted the emerging pressure on the US market with crude oil and gasoline stocks rising by 16.5 million barrels last week. It will also be interesting to see the impact on refinery activity and whether production is beginning to be revised lower.