Oil Strategy, Explained: Demystifying the Oil Market

By Michael Tran
RBC Capital Markets, LLC
Published May 1, 2020 | 3 min read

As COVID-19 ravages the global economy, the oil industry has suffered the impacts. April 20 was a historic day when West Texas Intermediate (WTI) prices closed in negative territory, begging the question if this event could be repeated. In our research report “Oil Strategy, Explained: Demystifying the Oil Market,” Michael Tran, our Energy Strategist, explains some of the nuances during the month that reshaped the oil market.

Required Conflicts Disclosures

The oil market is a complex synchronization of the financial market, converging with the physical market during periods of WTI contract expiry and physical barrel delivery. Below summarizes five key impacts:

 

1. Oil barrel storage options

One of the factors in the historic negative pricing event reflected the lack of available storage for barrels. Storage capacity still exists across the U.S., but congested pipes and elevated storage levels had left barrels trapped without outlets. Oil that is stuck in a region with limited options can lead to disorderly pricing, leaving those holding physical crude scrambling for buyers.

 

2. WTI contract expiry

The WTI contract, offering market participants the opportunity to trade oil commodities, is a physically delivered contract – meaning that holding the contract into expiry requires an exchange of physical barrels. The - $37/bbl pricing episode occurred on the penultimate day of trading for the May’20 WTI contract, and coincided with the lack of available barrel storage. While most contracts had already rolled into the June’20 WTI contract, the few market participants exposed to the May contract were impacted by scarce volumes and liquidity.

 

3. Cushing, Oklahoma: “Pipeline Crossroads of the World”

The WTI contract specifies that, upon contract expiry, physical delivery of the underlying barrels be made at Cushing, Oklahoma. Given it is the physical pricing hub for WTI, Cushing is the pre-eminent crude oil storage center in the U.S.; however, there is currently little room remaining before storage congestion is challenged at the 15-terminal storage facility. And, while tanks are not yet full, much of the remaining capacity is fully leased in advance, as demand destruction has left physical players scrambling for availability to park a barrel. The private sector owns the storage facilities, and they strike contracts on a bespoke basis.

 

4. Global Floating Storage Economics

Given the scarcity of barrel storage on land in the U.S., some consider storing barrels on ships on the water. Despite what the media says, though, floating storage is a rare occurrence. Wide-scale floating storage has only occurred a few times in the past and is the most expensive way to store a barrel. Based on our analysis, to charter a tanker for storage economically, a deep contango must persist for four to six months or longer. Current pricing does not deem floating storage economical.

 

5. The Evolving World of Oil Market Participants

The participants in the oil trading community have drastically changed as a result of the 2008 Financial Crisis; there is a shrinking pool of pure-play commodity hedge funds, and several major investment banks exited the commodity trading space. The void due to fewer career energy participants has quickly been filled by the rise of algorithmically driven funds or black boxes. The liquidity gap is further backfilled by industry generalists who trade a broad macro basket, resulting in financial volumes crossing hands today at a rate seven times higher than ten years ago. Put simply, the sheer volume of paper contracts being traded is occurring at a higher notional level, turning over at a faster pace by a growing number of traders who have been increasingly headline-driven than previously was the case.

Ultimately, unearthing gems from deep-dive, intellectually rigorous fundamental analysis can often lead one to arrive early on a market call. Investor sentiment may ebb and flow alongside price volatility, but understanding the inner workings of the oil market will always prove fruitful, given the global and physical nature of the commodity.

For a deeper dive into the oil market nuances, read the full research report “Oil Strategy, Explained: Demystifying the Oil Market” authored by Michael Tran. For more information, please contact your RBC sales representative.

For Required Conflicts Disclosures, click here. These disclosures are also available by sending a written request to RBC Capital Markets Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7, or sending an email to rbcinsight@rbccm.com.


Michael Tran

Michael Tran
Managing Director, Energy Strategist, Global Research
RBC Capital Markets, LLC


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