Tuesday, January 13, 2009

How diabolically desperate are the oil exporting states?

The oil market is currently in super-contango.  That is the forward prices are much higher than current prices.

Usually speculators fix this.  Buy oil now, store it, sell it forward and make a profit.
But the easy storage is full.  The WSJ reports that people are buying tankers to moor off the coast of Scotland to exploit the arbitrage.  It looks to be a surprisingly good trade.

So given the storage is full it is possible that the super-contango exists.  However a super-contango has implications – both for investment and geopolitics.  This post explores those implications.

What is happening in the oil exporting states?

Not all storage is full.  Most oil is stored in the ground.  It has been for hundreds of millions of years – and the ground storage is mostly stable.  

Surely the oil exporting states (Russia, Saudi Arabia, Venezuela etc) can store the oil and release it later – and hence take advantage of the super-contango.  

But for some reason they are not doing so.  I have a couple of theories:

Theory 1: the oil exporters are diabolically desperate for cash

The most obvious theory (not necessarily correct) is that that oil exporters are diabolically desperate for cash.  They can’t defer today’s cash receipts for much bigger ones tomorrow.

Usually if you have a really good investment idea (oil storage appears to be one) then there is finance available.  But seemingly there is no finance and Gazprom amongst others has liquidity issues.

We know about Gazprom – but most of the oil exporters – certainly the ones alleged to have excess capacity to bring the oil to the surface in the future – are in the Middle East.  If they are all that diabolically desperate for cash it has geopolitical implications.  Collapsed economies are not pretty.

Theory 2: there is insufficient extraction capacity to bring the oil to the surface in the forward period and hence take advantage of the contango

My second explanation is that there really is no ability to store oil in the ground this month to extract extra oil in (say) 18 months because the exporters are short extraction capacity.  This seems unlikely.  Opec claims it is cutting back production – which implies they are leaving some capacity idle.  They could however by lying.  There might not be all that spare capacity around.

In which case you want to get really long the drillers and anyone else who provides oil extraction capacity.  

I have no third explanation.  But in summary either the oil exporters are diabolically desperate for cash (and their economies are about to totally fail) or OPEC is lying about oil capacity and they are really constrained – or a combination of the above.

If anyone has a third explanation I am really keen to hear it.



Anonymous said...


Oil is such an essential commodity that perhaps political pressure is being applied to keep the oil flowing. "If you hold back the oil now looking for higher prices, we might look elsewhere when our economy improves and demand increases".

Investor (Chimes)

But What do I Know? said...

Wow!! I never thought about it that way before. . .

Is it possible that someone has sold too many out-month futures expecting the contango to narrow and is now having his/her head slammed against the wall every hour of every day? I doubt it but it is another way.

Thanks for the insights.

Anonymous said...

If you believe speculators were driving the price up earlier in the year, could they not be driving the price down now? I'm not a believer in speculators being a *big* driver of oil prices, but it's kind of funny that you haven't heard any talk of that in the media with low prices.

Is it possible that this is partly a game of chicken by oil producers. There are large fixed costs in stopping production and then re-starting. You really want other producers to cut first (and reduce supply/increase prices) so you can avoid those costs.

I still think the desire for cash is the main driver. Imagine a country like Mexico that has had its production drop quite rapidly over the last several years. As the price was going up, it hid the fact of produciton dropping. Now the price is low again, I imagine it's just a matter of time for problems to emerge there. There is simply no way they will cut production as long as they are making money.


Hemant said...

complicated game theory perhaps? Each oil exporter thinks :
1) it has infinite oil, and is constrained by OPEC quota as upper bound
2) so it wnats to sell as many barrels this month as it can, AND sell as many as it can 6 months later. Even selling at this reduced price is better than not selling oil
3) No point in stopping any production now.

Doesnt wash?

Mark Cheshire said...

I see it as dynamics driven by inventories and oil traders at the margin. Since spot price began its dramatic collapse, and futures prices we always a bit sticker, more and more oil traders took advantage of the obvious trade to buy spot, sell the future and store the physical in the meantime. As the old futures trades unwind it dumps an ever increasing quantity of oil on the market thus depressing the spot price even more.

This cycle will continue until it is no longer economic (lack of cheap storage). Then when the the contango narrows and spot oil start increasing, the accumulated inventories will be drawn down leading to ever less flow of oil.

In order for dynamic to take place it required two ingedients: the dizzy drop in stop prices, and cheap storage due to the fall in Baltic Dry index. I have no data to back up this idea, but if anyone has a source for inventory info it would be a way to check.

The way I am trading this is long USO and writing covered calls with have huge volatility premium.

Anonymous said...

A third (partial) explanation could be that the market for the physical stuff at spot and the market for paper futures are composed of different people with different views. In the spot market actual producers and consumers dominate. In the futures market investors (or speculators if you prefer) dominate, although producers and consumers of physical are hedging of course. Could it be that these two groups have different vieuws of the development of the oil market?

Investors could see oil as cheap given that it has come down over 60% from the 2008 high and is cheaper then it has been for years. Producers and consumers may see oil as expensive still, looking at the marginal cost of production and the current development of demand.

marc.van.den.bosch said...

How do you square hypothesis 1 with Russia's shenanigans with Ukraine?

MP said...

Given the deficits of many OPEC members, there exists a "perverse supply curve": the less a barrel costs, the more they need to sell in order to keep their budgets balanced.

Anonymous said...

your last post on shorting jgbs leads to future oil price. if helicopters of cash are used in the future - US$ value will be reduced along with the value of the oil in storage. so perhaps oil price contango on a physical basis is only a marginal game

clifton said...

If an oil field is accessible by more than one country then each has to trust the other to store the oil there.

Adam said...

My argument would be a variation of the free rider problem. If one state decided to slow oil production, oil prices would rise dramatically, transferring wealth to those producers who kept the wells open. As such, the benefits accrue to the group while punishing the benevolent actor.

However, many of the exporters are still 'diabolically desperate.' Russia, Venezuela, Iran and the UAE are all in desperate need of money to close budget deficits or fund overindulgent investment programs. Can't say why that would apply to Saudi Arabia, though.

Anonymous said...

Perhaps while the spot price was cliff diving, they decided to lock in future prices, and have thus sold off most or all of their forward supply.

KLM said...

I think anon#3 is right. The cost of shutting down is higher than the cost (in reduced prices) of keeping production now. Besides, it's a matter of physics; the pressure in the wells will not maintain itself (unless you're going to seal off the well entirely), and with this maintenance comes a cost, so basically you want to empty a well as soon as possible once you've opened it. Thus, you will usually make more money if you continue to produce than you would if you don't no matter what the other guys do.

Kinda like the prisoners dilemma.

A few players are big enough to move on their own, Gazprom being one of them, though. Hmmm.... I've always assumed it's Ukraine stealing gas that's causing the current conflict. Perhaps things are not so easy after all.

Konstantin said...

Russians do not really have the capacity to store much oil and wait for prices to rise.
When prices fell and export duty not adjusted in time in Russia, export railroad route was stuffed with full oil trains used as a temporary storage and waiting for export duty to sink - not a very efficient thing to do, eh?
And Gazprom deals mainly in natural gas, which is completely different matter for now wrt prices

Anonymous said...

Instead of buying the physical stock and looking for storage facilities, thus incurring additional cost, and paying the full price for it. Why not buy this commodity through the financial futures market without or with minimal margin financing. The market is almost near bottom and without margin financing, one should be able to ride through the present volatility.

cgaros said...

last anonymous: That's what the post is about. People are buying futures at high prices in anticipation of price rebounds, because holding futures is a lot easier than holding physical oil.

The other aspect of high futures pricing is that companies which got burned last year on oil pricing are probably hedging much more actively this year. These companies may not be in the oil-storing business and just want to make sure their costs are locked in at a reasonable level. They have to eat the contango, but it's better than paying 140/barrel again next summer (potentially).

Anonymous said...

To Anon. at 1011: "Why not buy this commodity through the financial futures market without or with minimal margin financing."

What happens when the futures expire and you have to roll..?

To Mark Chesire: please can you explain your strategy. You're selling the synthetic put on the front month future, which I presume is because you think the price is floored above your strike. Is that correct?

bdrasin said...

maybe they are under political pressure from the US to not cut production?
Or does no one give a s*** what we think anymore?

CP said...

Future prices are factoring in hyperinflation/devalued dollar. You need to discount the future prices & come up with today's value.

Mark Cheshire said...

To Anonymous:
Today for example you could buy USO at $31. Then you could immediately write March 31 Calls and collect $4.5 premium for each share. If the calls are executed it is 15% return over 2 months. If they are not executed I roll into a couple of months further out. The price could drop so sharply that you end up taking a loss, but unlike a bank I am certain that oil will always have a floor.

Neil said...

I don't think diabolical means what you think it means; or it doesn't point the point you think it points.

epicaricacy said...

To figure it out, why not compare the relative steepness of each contango for different grades of oil, to determine if it is the oil exporting nations that are desperate.

Surprisingly US traded grade oil has the steepest curve
NYMEX March 2010 is oil is 40% higher than March 2009 oil

The same ratio for Oman oil is only 28% and is 29% for Brent, but I don't know if this has to do with liquidity issues in the that futures market, or if it actually says something about the relative time supply of the different oil markets.

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Chidinma Nwoha said...

Oil is such an essential commodity that perhaps political pressure is being applied to keep the oil flowing. "If you hold back the oil now looking for higher prices, we might look elsewhere when our economy improves and demand increases" take Nigeria for instance, the oil prices increase on a daily basis irrespective of the poor masses in the society. isn't that brash?
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