Something is not right in physical oil

Supply disruptions are not enough to create a really out of control bull market, says John Dizard

Something is not right in physical oil©Bloomberg

The pleasure is momentary, the position ridiculous, and the expense damnable.

Attributed to Philip Stanhope,
fourth Earl of Chesterfield, 1694-1773

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Something is not quite right in the market for what is called physical oil, the stuff stored above ground or aboard ships. Given the structure of the oil price curve, which is pretty flat over the next year, it should not make sense for the commodities investor to take a hedged position in physical oil, particularly oil held in floating storage on ships.

Last week there was a 5.1m barrel (MMbbl) reported decline in oil stored in onshore terminals in the US, which led to prices popping up over the $50 mark. This was commonly attributed to the delayed effect of the wildfires in the Canadian oil sands region. Almost everywhere else in the world, though, there was lot of oil being pumped into tankers.

That is being done at a damnable expense to producers’ or speculators’ equity. Contrary to election-year rhetoric, JPMorgan, Goldman Sachs and the other big banks are not eager to finance oil “cash and carries”. That is, they are not inclined to use up their balance sheets to earn thin profits on secured commodities trades. As one oil trader told me last week: “The market is not respecting fundamentals.”

By fundamentals he means that a professional is not supposed to take a position on the future direction of the overall market, but to seek out time and location arbitrages that can be closed without taking on excessive risk. If a trading house is giddy with excitement it might take on some basis risk between different grades of a commodity, but betting on a general price rise or fall . . . not done.

Still, there is a momentary pleasure to be had by the speculator in gloating over the paper (or electronic) profits from owning oil since the price levels bottomed out in late January and early February.

In contrast to the physical-oil speculators’ apparent surrender to gambling madness, the producers’ capital expenditure is being cut and squeezed as a rational model would suggest. Dollar-denominated junk debt issuance is down to just $7.8bn in the year to date, all of it coming from two national oil companies, Petrobras in Brazil and YPF in Argentina.

And US oil production is on an accelerating downward slope as producing fields deplete faster than new wells are drilled and completed. Just as official statistics underestimated the rise in production as the unconventional oil boom played out, so the Energy Information Administration (EIA) is now revising its estimates of future production downward.

Bob Brackett, a geologist and senior analyst at Bernstein, the asset manager, has had a good record in estimating US oil production declines this year, which he and his team now put at 690,000 barrels a day (b/d), compared with an EIA estimate of about 500,000.

The wildfires in the Canadian oil sands region also gave some cause for optimism among the physical speculators. Now, though, it seems the damage will be largely limited to workers’ housing, which, while individually tragic, can be overcome with quickly manufactured units.

The market is also waiting for the rest of the Venezuelan script to play out. The next big drop in exports, of perhaps 300,000b/d, is likely to come from the country’s inability to pay for the imports of light crude needed to dilute its heavy-oil production.

All these supply disruptions are not enough to create a true panic and liquidation phase needed to lay the foundation for a really out of control bull market in oil. For that, and for my own guess of a $70 per barrel price within the next year to come true, we need to have a short-term oil price decline pretty soon.

There are two groups who think they can win at this game in the medium term. First, there are the managements of national oil companies, who are always in a struggle with other bureaucrats. They have a hard time getting funds appropriated now, but can easily lend themselves the above-ground excess production.

The other group is private investors who are building yet more onshore storage tanks. They want to move their oil in floating storage to points closer to where the refiners can take delivery. They think they are location arbitrageurs in the guise of speculators.

My own view is that this reflects both the likelihood of a commodities boom over the next year and a half, coupled with a profoundly pessimistic longer-term outlook. Those oil tanks are being built for resale, not for long-term use.

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Something is not right in physical oil
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