SEPTEMBER 14, 2009, 3:50 P.M. ET.
The Old Man and the Sea Of Oil
By LIAM DENNING
Oil bulls are putting their faith in an old man and a little boy. They hope the former, septuagenarian Saudi Oil Minister Ali al-Naimi, is right in saying there has been "a fundamental change" in the oil market. They hope the latter, the weather pattern called El Niño -- "the boy" -- will go easy on them.
Mr. al-Naimi, speaking ahead of last week's OPEC summit, was trying to draw attention from extraordinarily high oil inventories, emphasizing instead that the global economy is recovering.
Mr al-Naimi's language -- with shades of a "new paradigm" -- should unnerve bulls. So should market data.
It's true that oil prices kept climbing even as inventories rose, which is odd. Fears of "peak oil," the impact of Chinese demand, and inflation helped fuel interest in futures contracts, pushing up forward prices. The resulting contango -- when the futures curve slopes upward -- made it extraordinarily profitable to buy crude, store it, and sell it forward. Assuming 80% leverage, a 3% cost of debt, and 50 cents per barrel per month in storage costs, buying physical crude and selling it 12 months forward netted returns above 50% as recently as April.
The danger comes when, as now, the forward curve flattens. The contango has narrowed by roughly half since late July, with the 12- month contract now trading about $5 above front month oil. Using the assumptions above, the trade now generates a loss of 18%. Sure enough, inventories in the U.S. -- which uses a quarter of all oil -- have fallen steadily since early August, although they remain very high.
Absent a "V-shaped" economic recovery, therefore, the risk is of a glut of inventories being liquidated. Certainly, the strength of crude prices is not translating into better refining margins, which have weakened around the world -- a sign that final demand is lacking. Valero Energy, America's largest independent refiner, last week announced further shutdowns.
A big worry, now summer is over, is the overhang in distillates -- primarily diesel and fuel oil. U.S. refiners usually shift output from gasoline to distillate as winter approaches. But with distillate inventories almost a quarter higher than the five-year average, there is little incentive to run refineries all out. That means less demand for crude.
El Niño, which can mean mild winters in North America, could exacerbate this. The Climate Prediction Center last week said El Nino would strengthen through fall and winter.
OPEC may well have to revisit its sanguine view on inventories. Yet OPEC's compliance with earlier production cuts has dropped from 83% in March to 66% in July. The cartel's willingness to forego more revenue by cutting production could be all that stands in front of a big move downwards in oil prices this winter.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
Mr. al-Naimi, speaking ahead of last week's OPEC summit, was trying to draw attention from extraordinarily high oil inventories, emphasizing instead that the global economy is recovering.
Mr al-Naimi's language -- with shades of a "new paradigm" -- should unnerve bulls. So should market data.
It's true that oil prices kept climbing even as inventories rose, which is odd. Fears of "peak oil," the impact of Chinese demand, and inflation helped fuel interest in futures contracts, pushing up forward prices. The resulting contango -- when the futures curve slopes upward -- made it extraordinarily profitable to buy crude, store it, and sell it forward. Assuming 80% leverage, a 3% cost of debt, and 50 cents per barrel per month in storage costs, buying physical crude and selling it 12 months forward netted returns above 50% as recently as April.
The danger comes when, as now, the forward curve flattens. The contango has narrowed by roughly half since late July, with the 12- month contract now trading about $5 above front month oil. Using the assumptions above, the trade now generates a loss of 18%. Sure enough, inventories in the U.S. -- which uses a quarter of all oil -- have fallen steadily since early August, although they remain very high.
Absent a "V-shaped" economic recovery, therefore, the risk is of a glut of inventories being liquidated. Certainly, the strength of crude prices is not translating into better refining margins, which have weakened around the world -- a sign that final demand is lacking. Valero Energy, America's largest independent refiner, last week announced further shutdowns.
A big worry, now summer is over, is the overhang in distillates -- primarily diesel and fuel oil. U.S. refiners usually shift output from gasoline to distillate as winter approaches. But with distillate inventories almost a quarter higher than the five-year average, there is little incentive to run refineries all out. That means less demand for crude.
El Niño, which can mean mild winters in North America, could exacerbate this. The Climate Prediction Center last week said El Nino would strengthen through fall and winter.
OPEC may well have to revisit its sanguine view on inventories. Yet OPEC's compliance with earlier production cuts has dropped from 83% in March to 66% in July. The cartel's willingness to forego more revenue by cutting production could be all that stands in front of a big move downwards in oil prices this winter.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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