By Ole S. Hansen
While the US stock market, led by technology, healthcare and media, continues to send a signal that all is well you only have to look beneath the surface to find that it is not the case. Massive amounts of stimulus have found their way into the stock markets but not to the man on the street with unemployment rising and consumer confidence plummeting. These developments have put many government and health authorities under considerable pressure to reduce lock downs.
While some may be successful many are not yet ready and the impact on growth and demand will continue to deteriorate. These developments continue to be most visible across key commodities as they respond to demand more most other sectors. The table below shows the impact on key commodities since the Covid-19 pandemic became known outside of China. Growth and demand dependent commodities have taken a tumble while some key agriculture markets and not least gold have been the few winners.
Crude oil created history last week as hit slumped to uncharted territory while natural gas rose in anticipation of lower oil associated supply as wells get shut down. Gold rose to near a seven-year high as investors continued to diversify investments away from stocks and cash. China’s purchase of food commodities picked up while industrial metals held steady with virus driven supply disruptions to a certain extent countering the risk of a slowdown in demand as recession begins to bite.
One story drowned out most other commodity news this past week. The historic drop below zero in the expiring May WTI contract on Monday brought home to everyone the stress that currently reverberates across the global oil market. The Covid-19 related slump in global demand, estimated by the International Energy Agency to reach 29 million barrels/day this month, has sent millions of barrels into storage.
Once produced, crude oil needs to be consumed by refineries or stored in tanks, pipelines or at sea on Very Large Crude Carriers (VLCCs). In the event of storage facilities hitting tank tops, oil producers can only produce what they can sell. The risk of that happening is now the biggest challenge facing the industry. Such an event could force the shut-ins of millions of barrels/day and ultimately lead to bankruptcies and a sovereign debt crisis. Oil producers have been caught off-guard and have struggled to respond with corresponding production cuts. Saudi Arabia’s very ill-timed decision to hike production was reversed within weeks when OPEC+ agreed to cut production during the Easter break by 9.7 million barrels/day, starting from May. Global lockdowns have slowly begun to be get lifted but the process of returning to previous demand levels could take many months. Weeks not months, however, is the time it will currently take before global storage facilities hit tank tops. One area which has already reached full capacity are the storage facilities located in and around Cushing, Oklahoma. With its 76 million barrel capacity it is a major trading hub for crude oil and the price settlement/delivery hub for WTI crude oil futures traded in New York.
While the current level of storage has reached 60 million barrels it was very clear from the price action in the expiring May contract that the remaining 16 million was no longer available as they had already been leased to handle May deliveries. Left with nowhere to store the crude oil that would be the result of holding a long May position into expiry traders were instead left scrambling to unwind positions into an increasingly illiquid market.
Adding to the pressure on crude oil was the increased participants participation of retail money flowing into oil ETFs. I fully understand the reason why an investor would see the current cheap crude oil as a great investment opportunity. This, on the assumption that the pandemic’s impact on demand, would be temporary and that the eventual recovery would be supported by OPEC+ production cuts and a sharp reduction in investments towards drilling for oil in the future.
While the idea makes sense, the execution of that idea did not. Oil ETFs tend to invest at the front and right now the cheapest part of the oil curve. The ETF provider holds a long position in that future and as long as the market remains oversupplied, they will incur a loss every month when they sell the expiring contract to buy the next at a higher price. This phenomenon is called ‘contango’ and it creates a major headwind for investors. At the time of writing the spread between the June contract and September (3 months out) is 60%, that’s how much oil needs to rally in just three months in order for the ETF to break even. The United States Oil fund (USO:arcx) suddenly became a giant bull in a china store as the fund held a disproportionately high percentage of the whole market. As the market tanked the risk of default rose. That’s why the June futures contract, which doesn’t expire until May 19, suddenly slumped below $10/b on Tuesday while Brent crude oil was pulled down with it and reached a low of $16/b.
Since then, however, the market has managed to recover some ground. Of the four reasons, only one could have a longer-term positive impact on the price. They were:
The CME Exchange, which operates the WTI futures contract, hiked margin on holding a contract (1000 barrels) to $10,000.
Several banks and brokers introduced trading restrictions on the June contract meaning that existing positions could be closed but no new positions could be opened.
The USO ETF faced with a potential risk of collapsing reduced their exposure to June from 80% to just 20% after rolling futures contracts to July, August and even September.
President Trump threatening to destroy Iranian gunboats should they continue to harass US navy ships in the Persian Gulf.
While the latter carries the risk to the potential safe passage of supply through the Strait of Hormuz, the others are mostly of a technical character. On that basis we’ll continue to see limited upside for crude oil until lockdowns are eased leading to a pickup in global demand or unfortunately, more likely that many high-cost producers are forced to cut production, either voluntary or involuntary.
[Ole Hansen is Head of Commodity Strategy at Saxo Bank)