Contango & Cash

Crude oil’s historic run into negative pricing

This week one topic has dominated the financial news cycle- collapsing oil prices that at one point went deeply negative on Monday. As oil futures contracts came due, traders were left desperate to offload contracts rather than take delivery of the physical product, leading to a situation where they were paying to people to take these contracts off their hands. The reason? There is just not enough storage capacity available given the precipitous fall in demand for oil and its derivative products.

The storage issue has been known for weeks, and it had been priced in to a considerable degree: contango was already at a historically high level. What’s contango? A situation where the futures price of a commodity is higher than the spot price. In contango, investors are willing to pay more for a commodity at some point in the future. The premium above the current spot price for a particular expiration date is usually associated with the cost of carry, which in the case of oil mostly is made up of storage costs.

In other words, those with the capacity to move and store crude oil could make a significant profit simply by buying the stuff on the cheap, storing it, and selling it for a higher price at a later date.

Why is contango happening in oil markets?

Because of the effective shutdown of the global economy due to COVID-19, current demand for oil has collapsed. Estimates for current oil demand destruction range from 20-35 MBD (million barrels per day). Even with full compliance of the OPEC+ production cuts of ~10MBD that will take time to implement, the world is still oversupplied oil by roughly ~15 MBD and that means more oil is going into storage.

With the bulk of the world’s onshore storage near capacity and US storage rapidly filling, even China buying as much as they can to fill their strategic reserves isn’t enough to relieve the supply glut. This is causing oil (both crude and product) to be pushed offshore, leading to an unprecedented situation in the oil tanker markets. Not surprisingly, the widespread use of tankers for storage of crude and products was is in-line with comments about a delay or slow walk to the targeted production cuts owing to a lack of onshore Russian oil storage and the time it takes to shut-in production.

So floating storage is experiencing an unbelievable surge, already blowing past records, and showing no signs of stopping. This comes in the form of both logistical bottleneck tanker storage, as there’s no place for the product to go, and some product contango storage.  While VLCC tanker storage (estimated around 60 VLCCs and counting) is garnering the headlines, smaller crude and product tankers are also being used for storage. The latest data suggests 150M barrels are stored across 174 vessels. Keep in mind these are already loaded tankers. Someone who wanted to hire a VLCC today (“Very Large Crude Carrier,” 2M barrel capacity) likely couldn’t achieve a loading berth until mid-May at the earliest. This storage demand is happening concurrently with an already tight market for tankers, which is having a blowout effect on tanker rates:

Under these market conditions, a VLCC can earn more cash flow in a single route for 60-80 days than in nearly five years of normal operations. Additionally, these ships can be chartered for longer-term floating storage operations, with recent VLCC fixtures of $105k/day for 6 months and $48k/day for 3-years.

So what does this oil contango mean for someone trading oil? If someone managed to charter a VLCC for 6 months at $105k/day starting in June for delivery in December, they would have to pay ~$19.2 million for the floating storage. Why would they do it? As I’m writing this, WTI futures for June are trading around $11.50/barrel, while December contracts are $27.50/barrel. At 2 million barrels, that works out to a price difference of $32 million. After paying for the storage, they would be sitting on $12.8 million dollar profit for storing oil for 6 months. In percentage terms, the return on investment from such a trade would be 30.3%, or nearly 70% on an annualized basis.

Obviously the logistics of actually pulling this off would take a significant amount of legwork, and that’s under the assumption that you could actually charter a VLCC or some other vessel for storage for the coming months, which is far from guaranteed. But given the rates that tanker companies are being able to charge, and the unprecedented cash flows that they can expect due to this contango, investing in the tanker companies themselves could be an extremely attractive investment opportunity.

What tanker companies are exposed to this trade?

If you’re looking for exposure to firms with a large number of VLCC vessels, Euronav (EURN) is among the most concentrated in terms of its fleet. VLCCs make up about 65% of their fleet (nearly 80% by tonnage). The next largest concentration is with International Seaways (INSW), nearly 70% by tonnage. Frontline (FRO) is another option and their current fleet makeup is about 45% VLCC by tonnage. With surging LR2 rates also emerging due to jet fuel storage demand, Scorpio Tankers (STNG) is another potential winner.

While tanker stocks tend to be highly volatile, the fact that these firms are set to earn years of cash flow in a matter of months make this an attractive opportunity, regardless of the long-term fundamentals.

Full disclosure: Our clients hold positions in Euronav (EURN), International Seaways (INSW), Frontline (FRO), Scorpio Tankers (STNG)