The Unlikely Winner in the Oil Wars
‘Oil went negative,’ I tried to emphasise to a friend back in April.
It’s becoming trading folklore now, but back in April one West Texas Intermediate (WTI) crude dropped more than 300%, and for a short time there was trading at minus US$37.00 per barrel.
Something that has never happened before.
Not only that, I said to my friend, I’m surprised that New York Mercantile Exchange allowed it to trade negative. There were no circuit breakers like the S&P 500 or the Dow Jones have.
Never in my career did I think I’d see something like this happen. That technically speaking, the producer of a product would need to pay a customer to take it off their hands.
Obviously, that’s a simplification of the futures market. But for the few minutes that oil was negative, that’s what it meant.
While this trading anomaly didn’t last long, there’s a more interesting trend developing around the world.
You can’t just stop an oil well. They aren’t like a light switch. Once you start pumping, there’s a whole host of events that take place before you ‘plug’ the oil hole.
What this means is, not only has demand for oil collapsed globally. But production of the black stuff continues.
Here’s the thing. It has nowhere to go either. It’s not going to cars or diesel trucks, or even in fuel. As Jim points out today, there is an increase of oil floating at docks around the world, because there are no storage facilities available.
Read on for more.
Until next time,
The Unlikely Winner in the Oil Wars
Most wars are bad ideas for a host of reasons. This has led historians and political scientists to study the causes of them.
If wars are such a bad idea, why do they keep happening?
One conclusion of this research is that wars happen because of excessive optimism.
If two adversaries both believe they can win (an impossibility), then wars emerge despite the fact that one side (sometimes both) are bound to lose.
A perfect example of this dynamic is the oil price war between Saudi Arabia and Russia that broke out on 8 March 2020.
Although this was a price war, not a shooting war, the dynamic is the same.
Saudi Arabia believed it could drive Russia to reduce output. Russia believed it could outlast Saudi Arabia in a war of economic attrition. So far, both sides are losing.
The Saudi-Russia price war had its roots in the earlier failure of OPEC to agree on oil output reductions.
Russia wanted to keep its oil output high because it needed the money to prop up its own economy and fund its foreign adventures in Syria, Ukraine, and Venezuela.
Saudi Arabia refused to be the compliant swing producer that would reduce its own output to prop up prices while Russia (and US frackers) reaped the rewards.
Saudi Arabia instead expanded its output and announced price discounts of up to $8.00 per barrel to preferred customers, especially China.
This led to a free fall in oil prices with oil dropping from about US$40.00 per barrel immediately before the announcement to zero on 20 April. That’s a 100% price collapse.
Oil has since rebounded to about US$17.00 per barrel as of 27 April, but that’s still a 57% price crash in just seven weeks…
Oversupply and nowhere to store it
Saudi Arabia’s timing could not have been worse.
Their price cuts and output increases perfectly coincided with the collapse of the global economy as a result of the Wuhan virus pandemic (COVID-19).
Global demand for refined products collapsed as business lockdown orders proliferated and consumers in the US, Europe, and Japan simply stopped driving.
The result of a surge in output and a simultaneous collapse in demand meant that oil storage was at a premium. If the oil was being produced and sold, but not consumed, it had to be stored.
This could take the form of oil tanks on land, ships at sea, and strategic capacity in the hulls of its fleet of oil tankers.
Oil storage facilities are filled to capacity with still more oil on the way.
What are the prospects for oil storage in the months ahead?
Right now, the action nodes are telling us that oil storage capacity is scarce, oil output is continuing at a near-record pace, and the imbalance between huge supply and tight storage capacity will not correct soon.
The storage capacity shortage in the midst of an oil production boom will benefit oil storage companies and tankers alike.
On the one hand, they benefit from having full tankers chartered for the purpose of moving oil from Saudi Arabia (and other OPEC members) to customers in Asia.
On the other hand, the tankers have nowhere to unload the oil when they arrive.
The result is that the tankers are moored indefinitely near their destinations (many in Singapore) as ‘floating storage facilities’.
This storage role then creates a shortage of available tankers, which raises tanker charter rates even further.
Floating storage is not free.
Owners of the oil cargoes must pay ‘demurrage’ to the owner of the vessel. Demurrage is a shipping term roughly equivalent to ‘rent’.
Since the tanker is out of service while being used for storage, the cargo owner must pay the ship owner for opportunity costs, crew costs, insurance costs, and other charges that would normally be covered by the next charter.
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Trading experts saw the opportunity
The oil world changed dramatically on 8 March, when Saudi Arabia commenced the oil price war with Russia in a fight over market share.
This happened almost at the exact time the coronavirus pandemic started to impact the US economy and the US lockdown began.
Now, the issue was not demand (which remained weak and getting weaker), but supply. Since supply was expanding and demand was collapsing, there was only one way to reconcile the two factors — storage.
This dynamic of huge profits coming from the smart use of oil storage capacity was illustrated by reporter Erik Schatzker in Bloomberg on 24 April.
This excerpt describes the efforts of legendary investor Carl Icahn to exploit an oil futures pricing anomaly by mobilising oil storage capacity in a company (CVR Energy) that he controlled:
‘The billionaire raider-turned-activist [Icahn] took advantage of the historic collapse in crude futures to supply his Midwestern refiner, CVR Energy Inc. He said CVR tried to purchase 1 million to 2 million barrels of oil when prices went negative in a technical quirk of futures trading that temporarily forced sellers to pay to have contracts taken off their hands.
‘It’s a role Icahn, a wily investor with gifted timing, has played before. In one of his more legendary trades, Icahn left Donald Trump’s election-night victory party in November 2016 to buy $1 billion of U.S. equity futures as stocks slumped in the early hours of the morning.
‘Monday presented a similarly rare and short-lived opportunity. With oil markets oversupplied and running out of storage space because of the coronavirus pandemic, at about 2 p.m. crude for May delivery fell below zero and began an unprecedented plunge to less than minus $40 a barrel. Investors with no use for the physical commodity and no place to keep it next month became increasingly desperate to unload contracts.’
Schatzker continued his coverage of Icahn’s oil trading strategy in Bloomberg on 25 April:
‘Many of Icahn’s larger stock holdings are in industrials such as oil refiner CVR Energy Inc. and Tenneco Inc., the auto-parts maker. They’ve been battered by the pandemic.
‘“We keep it pretty well hedged, but even the hedges couldn’t stop us from losing some money,” he said.
‘A wily trader, Icahn spotted a once-in-a-lifetime opportunity amid the market gyrations. On 20 April, when it seemed the whole world was selling oil and crude futures fell to an unheard-of minus US$40 a barrel, he was buying.
‘Because CVR constantly needs oil to supply its two refineries, Icahn realized he could use it to profit from the frenzy. He said he instructed the Sugar Land, Texas-based company to make space in its storage tanks and put in orders for 1 million to 2 million barrels at negative prices he doesn’t expect ever to see again.’
While the Icahn story relates to commercial land-based oil storage, the situation is no different with regard to tanker-based storage or strategic petroleum reserves of major countries such as the US and China.
The tanks are full everywhere you turn, but the oil keeps flowing.
All the best,
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