Inventory levels and contango

From the EIA report this Wednesday, crude inventories are the highest since they started keeping reliable statistics in the early 1980s.  There was an editorial (which I can’t find now) saying that US inventories are the highest since 1931.  In the early 1930s, the East Texas Field was developed and a glut of oil came on to the market that nearly put the entire oil industry out of business.  Texas asked the federal government to come in and enforce a production rationing program to keep prices up and everyone from going out of business.  There is a good account of it in the book "The Prize" by Daniel Yergin.

 I’m starting to hear commentators say they think we have found a bottom here in the $40 range.  I don’t see any support for this, except that US producers and the majors are cutting capex and cutting the rig-count.  These measures will have long term consequences, but the short term spot price may still decline significantly.  Capex cuts will certainly support the price over the longer term though.

As I mentioned before the crude market is in contango now, meaning that futures are trading higher than the spot price.  Last summer it was in backwardation, meaning that the futures were below spot.  Contango rewards you for storing oil.  There is, and probably will continue to be, increasing demand for floating storage, as cheap storage fills up.  Incidentally if you would like some excitement, you can trade oil tanker stocks like TNK, DHT, NAT, TNP.  But be aware that these are highly leveraged companies in an incredibly volatile business that has a reputation for destroying capital that rivals the airline industry.

EIA also has estimates for OECD inventories (above), but the data quality here is probably worse than their domestic US data.  It does show an alarming build however.  And now we can also look at production numbers for the USA:

These production numbers are not as important as whole-world numbers.  But the USA is a high cost producer, and one of the countries that the Saudis say must cut production.  So far there is little discernible impact of the higher prices on US production.  Surely the rig count drop and the fast decline rate of shale wells will cause US production declines at some point, but we are not seeing it yet.  This brings me to the conclusion that this talk that we are now hearing that crude may have found a floor, really doesn't seem to have any short term basis.  Inventories continue to build, and there has been no peak in production.  Companies are not selling oil into the spot market because they can store it and sell it forward at a guaranteed profit.  Traders are doing arbitrage trades where they buy oil, sell it forward and store it on a tanker.  But there are only so many tankers, and only so much storage.

I would like to call attention to something that happened in the mid-continent ethane market in 2012.  The production was spiking from all the “wet gas” people were drilling and ethane storage capacity was limited.  Mont Belvieu is the main ethane hub on the gulf coast, and prices there dropped by 2/3 in 2 months.  In Conway Kansas, the other listed spot market for ethane, it traded down to about $.01 per gallon.  There was simply no place to put it.  Because it is only a component of natural gas production, you cannot turn off the production independently.

https://rbnenergy.com/lets-get-crackin-part5-natural-gasoline

Now I don’t believe that anything this dramatic can happen to oil prices, production would be shut in well before that.  But it does highlight that since there is a fixed amount of storage for oil, and as inventories build and production does not decline, there could be a further severe sell off in the spot market.  The recent ISIS scares in the Kirkuk region of Iraq could be an opportunity for a short-term bump for people stuck in a position.   Although if you think ISIS can capture the big fields in Shite dominate Basra region, you might be less bearish than I am.  That would solve this supply glut in an instant!