Global Oil Market - Sept 13

[dan_s]

Goehring & Rozencwajg Associates:
Global Resource Anomaly: Oil Market Term Structure 09/ 13/ 2019
Topics: Oil Markets, Commodities, Natural Resources

“While the conventional wisdom suggests the oil markets are in a sustained glut, the pronounced backwardization tells us that there is no truth in this belief.”

For nearly 30 years, we have been studying long, drawn-out bear markets. As we stated last week while discussing commodity prices relative to commodity stock prices, one of our observations has been that distinct anomalies develop at or near the bottom of these protracted periods of investor negativity.

As we discuss in the oil section of our most-recent letter, there is a widely held belief among investors that the oil markets are currently oversupplied. The fact that U.S. inventory behavior was weak during the first half has only added to this bearish outlook. We believe that recent inventory behavior has been skewed by various short-term issues stemming largely from issues surrounding the US sanctions against Iran. Moreover, in June, the IEA updated its outlook for 2019 and released projections for 2020 that again suggest oil markets will be oversupplied. < In this week's IEA "Oil Market Report" the agency says the global oil market will be under-supplied for a few months, but it will be over-supplied in 2020. - Dan.

There is an important anomaly that is pointing to sustained tightness in the physical market: the term structure. NYMEX futures for WTI and Brent at in "Bachwardation".

An oil market is said to be in "contango" when the future price for oil is higher than the current spot price. When the future price is below the spot price, the market is said to be backwardated. While it may seem counterintuitive, when the oil market is well supplied, the future price trades above the spot price (contango). In a physically tight market, the future price actually trades below the spot price (backwardation).

To understand why, consider that the future price of oil equals the current spot price plus the cost of capital and the storage cost less the “scarcity premium.” This last term is the premium an oil trader is willing to pay to have crude delivered immediately. In a normal, well-supplied market, the scarcity premium is de minimis relative to the cost of capital and storage cost and the future price trades above the spot price resulting in contango. However, when the physical market is very tight, the scarcity premium will overwhelm the cost of capital and storage and the spot price will actually trade higher than the far-dated futures contracts.

Despite the fact that most analysts continue to think the oil market is oversupplied, both WTI and Brent were backwardated from October 2017 to November 2018 (explains why oil prices rose sharply from January to April) and once again from early 2019 to present. Today, the 12-month WTI backwardation is running at $2.11 per barrel while the Brent backwardation is $2.61 per barrel.

While the conventional wisdom suggests the oil markets are in a sustained glut, the pronounced backwardization tells us that there is no truth in this belief. There is enough physical tightness in today’s market to bid up the near-term oil price for immediate delivery in excess of the future-dated contracts. This is a very unusual divergence and one that suggests the consensus bearish view is ultimately wrong.
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MY TAKE is that barring a significant recession, the global oil market is much tighter than "conventional wisdom".
> IMO the FEAR that a U.S. vs China Trade War will go on forever and cause a global recession is way over-blown. Plus, I think Trump is going to work out some kind of a deal with China. China needs it worse than we do.
> IMO the assumption that U.S. oil production will keep going up at any oil price is WRONG. The U.S. active drilling rig count will continue to fall if WTI stays in the mid-$50s.
> MOST IMPORTANT: The NYMEX Strip for oil is not a forecast; in fact it is the opposite. Twenty years ago, a very smart guy named Michael Economides who wrote "The Color of Oil" sat down with me at the Houston Petroleum Club and explained to me that when the NYMEX strip for oil is in backwardation it is a bullish sign for oil. Shortly after that discussion in early November, Michael forecast to a crowded room that the price of natural gas would double by year-end. Based on the crowd's reaction, I could tell that everyone thought he was nuts. Within less that two months the price of ngas went from $2.00 to over $6.00.