If you have been following financial news there is a good chance that your inbox would be flooded with charts of price crashes and the fear and surprise over the remarkable fall in crude yesterday.
In today's piece, we look into the specific contract that has seen the sharpest fall and compare this to alternate contracts for WTI and Brent, explore the piece central to the WTI puzzle, and attempt to understand the implications of the move on the world.
The May US Oil futures
The first reaction to seeing oil futures plummet to sub-zero is naturally fear. It helps, however, to take a step back and look at other instruments and see how they are doing - as this may tend to give you insights into why the May contracts have fallen so sharply.
Let's start with comparing with the WTI futures contracts for months post-May. June futures are still trading north of US$20, July north of US$25, and September north of US$30. The US$20+ differential between the contract expiring tomorrow and the contract expiring a month from now should provide some relief. A look at Brent, another global benchmark for crude points to a similar pattern.
So why did the May futures see such a precipitous drop? It may help to go back to one of the factors that are generally ignored, but becomes increasingly relevant in these times - physical delivery and the question of storage.
In one of our earlier pieces on Contango, we had covered the importance of storage space in a time of shrinking global demand. The US oil contracts have their physical delivery in Cushing Oklahoma, a place that is seeing his storage spaces filling up fast! The place has a storage capacity of ~75 million barrels and is currently 69% full. The sharp deviation between demand and supply means that the remaining 24 million barrels will probably be filled up soon, and will remain filled post that until demand begins to resurface or supply begins to fall off.
The next bottleneck will most likely be the pipelines. As and when Global demand restarts these lines will have to work at peak capacity to get the stored crude back to the world. In an absence of sufficient capacity in the pipelines, folks may be left with no option other than using physical oil trucks to move the oil out.
Is this the end?
The situation is indeed dire and will require suppliers to cut back production sharply in line with the demand environment. The optimism in the market that had begun to emerge will most likely subside, as this serves as another example that what we are dealing with is not a slowdown but a shutdown! On the crude side, the smaller players - debt-laden local horizontal drilling shale firms are likely to be hit first, with the larger firms operating at much lower breakeven costs will have a longer runway.
That being said it is important to realize that this is a financial instrument being squeezed because of a paucity of storage space, and tells us very little about the demand environment that you did not already know. And so while it does make for compelling TV, you probably shouldn't be taking any drastic decision based on yesterday's movement that you wouldn't have taken before yesterday.
About the Author: The post is written by Ganesh Nagarsekar. Ganesh is a graduate from IIM Calcutta and has worked with J.P. Morgan and Goldman Sachs, before founding GSN Invest.