Werner’s Blog: A price war and COVID-19 have put oil markets in “super contango”
In this excerpt from his latest blog post, Werner Antweiler, Associate Professor & Chair, Strategy and Business Economics Division at UBC Sauder, discusses the implications of the unprecedented global situation that has put oil markets in unexpected and uncharted territory.
When trading in commodities futures, a situation in which the future price exceeds the spot price is known as “contango.” This means that there is a forward premium and the forward curve is upward sloping. Contango situations are rare. The opposite, backwardation, is the default scenario. When a commodities market is in contango it means that there is an opportunity to arbitrage (the practice of taking advantage of a price difference between two or more markets) because buying and storing the commodity will deliver a guaranteed return on investment through locking in a sale through a futures contract. If the profit from this transaction is large enough to cover the storage costs (the cost of carry), then contango will be a very attractive investment option. Why does contango not simply go away through arbitrage? If storage capacity is limited—as it is for crude oil—then contango situations can persist as traders are simply not able to take advantage of arbitrage.
Oil markets have been in double turmoil for over a month. First, the COVID-19 crisis has significantly reduced demand for oil products. Second, the price war between Saudi Arabia and Russia has increased downward pressure. Even a recent Organization of the Petroleum Exporting Countries (OPEC) agreement to cut production by about 10 million barrels a day (about 10% of world production) is very likely not going to be enough to balance supply and demand. Some of the drop in demand for oil products has been compensated for by demand for inventory, but oil storage facilities are quickly approaching their limit. Storage at Cushing, Oklahoma, is expected to be full by mid-May, and storage facilities elsewhere in the world already have or will be soon approaching their limits.
Will oil markets recover? Shutting down and restarting oil production is costly, and thus producers try to avoid this drastic step until they have no other option. However, if demand is simply not there because of COVID-19, sooner or later cuts will have to be made far beyond what OPEC announced. Even if cuts are agreed upon, this does not mean that countries will stick to their commitments. There is a strong financial incentive to exceed the targets at the expense of other OPEC members. A recent Bloomberg News article showed this problem in detail. More cuts are needed and sooner than planned, and there is indication of accelerated production cuts.
Yet, the U.S. Energy Information Agency (EIA) presents relatively optimistic forecasts for total production for 2020. Their most recent April short-term economic outlook predicts average production of about 95 million barrels per day for 2020, down just 5 million barrels per day from 2019. The EIA expects a rebound in 2021. It remains to be seen if these somewhat rosy forecasts come to pass. Even if demand returns to normal, the current crisis may reshuffle oil markets. Marginal producers may not be able to weather this storm as well as more profitable producers. And this is what Saudi Arabia was aiming for all along when it started the price war: the battle is about market share.
If North American oil producers feel threatened by foreign competition, it is possible that North America detaches itself to some degree from international markets because North America has become self-sufficient over the last decade and a half. The US and Canada combined are net exporters of crude oil, not net importers. Given the market disruptions caused by the current crisis, it is not unthinkable that protectionism could arise even in global oil markets. Yet, even curtailing imports will not prevent hardship. Oil producers in Canada face massive cutbacks as storage capacity runs low. In the long run, today's financial losses and uncertain prospects for the future may also imperil much of the capital spending that was planned for the next years. Even if the economy returns to a more normal state of operation by the fall, the current crisis is very likely to cause lasting damage.