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Opinions5 Mins Read

Burning the Midnight Oil

Advisory Letter: 21st April, 2020

Just when I thought I’d seen about everything, a -40$ price on May delivery WTI crude popped up as yet another ‘unprecedented’ event in 2020. Yes, something has gone really awry on this one and a few dealer and retail accounts have been hurt. I wonder if weekend news of the Singapore oil traders Hin Leong bankruptcy and subsequent possible liquidation of inventory has something to do with it…

But besides the speculation about the possible reasons, let’s face the crude facts: Oil is trading at a record contango level thanks to two reasons: A record slump in demand due to COVID lockdowns and the fact that big storage hubs like Cushing, Oklahoma where delivery of the West Texas Intermediate futures contract takes place and middle eastern storage are running out of capacity soon at the current rate of inventory build. Cushing is rumored to be around 75% full.

This has led to traders selling the front month WTI futures contract at any price to avoid a situation where they will have to take delivery. (WTI Futures are physically settled futures, for 1 contract you’ll have to take 1,000 barrels of delivery) Lucky the one who managed to buy at -40$ overnight in what seems to be a panic sell.

But make no mistake, more informative than the headline-grabbing negative crude is whats happening in contracts that have a broader delivery schedule, like Brent. The Brent June Futures are still trading in the 25 area, and the price differential between June and September is similar to WTI. Also, we are reading reports that the US oil producers have reduced their output by an estimated 30% over the past 2 weeks.

Meanwhile, a record amount of investors has piled into oil ETFs like USO. USO is the Unites States Oil Fund LP ETF which saw a record inflow of over 3.4bn since 1. March from investors betting on a recovery in oil prices. Some may have been stopped out already, some may still be holding on to the last bit of hope of a quick turnaround.

USO invests typically into the front month of the WTI Futures contract (actually 80% front month, 20% second contract month), which means that a contango situation like right now, is severely hampering the return potential of this ETF. USO is rolling within 2 weeks of the expiry into the next month. This means, over the past 2 weeks, USO has shifted its exposure from the today expiring May contact into June by selling the May at around 20$ area and buying June around the 25-26 area. The same happens with any investor buying WTI futures contracts on the temptation of prices below 10. As time goes by and storage space is dear, a similar roll down may happen a few more times. So even if a speculator buys the Futures contract at a time WTI is at 15 and holds on for 3 months, if the contango stays at its current steep 5$ average per month, that would mean prices will have to double in 3months time just to get to break even.

So, for anyone buying into WTI or USO at this point in time, this has to be a clearly driven view on the supply glut to diminish and storage situation to abate, otherwise its unlikely to go anywhere. The inflows of USO have also made this ETF so powerful, that it  had earlier in April breached the exchange imposed maximum position limit. Therefore the manager had to change the strategy to term out 80% front month and 20% second month. A small, but not unimportant, technicality.

An ETF with a more termed out structure, and less reliant on the performance of the front month deliveries is the Invesco DB Oil fund, Ticker: DBO. This ETF is taking exposure to longer-dated futures contracts, therefore reflecting the longer-term average
For Accredited Investors we are able to price up some interesting alternatives at these levels too.

Either way, oil is going to remain the talk of the town for the next few weeks, that’s for sure!


The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.

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