It is old wisdom that one should save for rainy days. Somehow in the economics sense, this adage was lost, especially in the modern context of optimising between saving for the future, or investment and consumption in the present. With the existing low interest rates environment, there is much less incentive to store and save for the future.
Supply disruptions are rainy days:
In the oil markets, do players store for rainy days? This is especially pertinent with the overhang of geopolitical tensions in the Middle East – what with Iranian sanctions planned for the middle of year and a much debated but never concluded Iranian threats in the Straits of Hormuz. Obviously, the governments do not agree as the US, UK and France contemplate a strategic oil release. Critics write it is politically motivated with the coming Presidential elections in November. The release can be construed for smoothing price increases or for discouraging speculators away. Even more so, the timing and size of its release remain suspense to market players. My game theory lessons on incomplete information equilibrium taught me it is a wise act to prolong its intended deflating effect. Speculators anticipate its release and dare not go long, whilst governments leverage on the information asymmetry to its full effects.
The original intent for oil storage is to buffer against surprise supply shocks so that users (the refiners) can maintain operational effectiveness. This must be seen in the different interests of the commercial players (oil producers and trading houses) and governments that store strategic petroleum reserves (SPR) though. Whilst commercial players seek to maximise profits, governments seek to minimise supply disruptions from inexorable events.
Commercial and strategic storage:
A look at the graph of the crude stocks by the EIA shows negligible storage by the US DOE over the past few years. In fact, spring of 2011 shows a SPR IEA coordinated release in response to the Libya civil war disruptions. An increase occurred in the spring of 2009 to take advantage of depressed prices in the financial crisis. A plateau has since occurred for the last year in 2011. A similar inspection of commercial storage showed the same market behaviour during the financial crisis in the second half of 2008 and spring of 2009, with an increase of inventory by almost 50 million barrels over half a year.
The author hesitates to draw any conclusion during 2011 when Cushing tanks were full. This was a period when WTI started to lose its importance as an international benchmark. Noticeably though since the beginning of the year 2012, commercial storage has increased by 25 million bbls. Was this in anticipation of the Iranian sanctions looming in June?
Contango and backwardation:
An analysis of oil storage is not complete without examining the forward curve contango and backwardation. Historically, commodities markets are in backwardation norm as producers willing pay a spot premium for their operations. For the crude oil markets, this will be for the continued operations of refineries. After 2004, the oil markets begin to be ‘financialised’ and ‘globalised’ with more market players, and become more volatile with rising prices. The market structure flipped into contango seen in the graph below. The huge spikes above $10 in the second half of the 2008 and early spring 2009 during the financial crisis were periods mentioned when commercial storage increased greatly.
Post 2004, major investment banks decided to enter into physical storage play alongside existing oil trading houses (like Vitol and Glencore), realising there were profits to be made. For storage to work, these entities long the spot cargo and short the forward curve a few months out to lock in their arbitrage profits with the higher contango. In the process, they lease out storage tanks and pay a leasing fee ranging from $0.15-$0.50/bbl per month.
Oil speculation or storage? A conclusion.
These storage plays account for major profits among so called ‘speculators’ or non commercial players classified by the CFTC1. Back to the original question if oil storage increases prior to rainy days? Oil storage occurred not due to some prudent mind saving up for the rainy days, but for an invisible hand of the market. Investment banks and trading houses invest in storage plays and in the process sold down the forward curves a few months out. Although storage plays increase spot prices, this potentially helped to smooth future price increases. The present contango to June ’12 out is about +$1.5o as of end March – a result perhaps of the storage plays shorting and depressing the forwards. It would not be conceivable with the upcoming sanctions in June, the market ascribes only such a small premium from that month.
A re-look at the first graph on storage shows that actual oil storage has not changed much beyond the 1990s. In fact, storage was much higher during the 1990s, before the oil markets became ‘financialised’. This needs to be seen in context as oil prices were in the $10s and $20s back then and the opportunity and capital costs for storage were much lower. There was also a higher spare capacity of oil production.
1 – Other strategies are geographical arbitrage plays where physical players ship oil from one region to another to take advantage of regional price differences. An excellent example of geographical occurred during the Hurriance Katrina and Rita, when gasoline shortages in USA were quickly remediated with imports across the Atlantic. Physical blending or the undesirable pure flat price punt are other strategies.