Still Floating – An Update on Oil Markets

Seven weeks ago, I wrote a post about the contango in oil markets. To summarize, the world was falling apart and there was nowhere to put all the extra supply of crude oil and refined crude products, causing oil to briefly trade negative and oil tanker rates to skyrocket. As a result, tanker companies presented an extremely attractive investment opportunity.

What We Got Wrong

The length and severity of the oil price contango. The price of oil has rebounded significantly since its collapse into negative territory in April, leading to a flattening of the crude oil forward curve and a reduction in the contango opportunity:

Oil term structure - what a month it has been

So what happened?

In April, OPEC+ pledged to cut oil output by 9.7 million barrels a day, or roughly 10% of global oil supplies. A few weeks later, Saudi Arabia and its closest allies in the Persian Gulf pledged  an additional supply restraint of 1.2 million barrels a day starting in June. Oil prices rebounded to around $40 a barrel.

Over the past weekend another deal was reached to further extend cuts for an extra month. Seemingly, this puts a floor on oil prices while demand is still depressed across the world. But with OPEC+, there are always problems bubbling beneath the surface.

First, the deal to further extend cuts through July is conditional on other members making deeper cuts over the next few months to make up for their past non-compliance to output curbs (here’s looking at you Iraq, Mexico, Nigeria and Kazakhstan). But the only recourse that Saudi Arabia and Russia have if other members don’t comply is to phase out the supply curbs that are putting a floor on the market, and return to a price war that can only marginally benefit the lowest cost producers.

Whether the threat of another price war is enough the big question, particularly for the countries with the weakest finances that may look for any short term gains. While the production cuts have worked better than expected, despite the lack of full compliance by members, and caused the price of oil to rebound, the higher prices are exactly what incentivizes countries like Iraq to further cheat on production curbs. In other words, oil production volumes have likely reach their nadir.

As a result, we can expect to see more price instability in the coming months, as long as there is still depressed demand, and varying degrees of contango going forward.

Demand? What demand?

As expected, even with the oil productions cuts, there is still a significant decrease in demand as a result of the global economic shutdown.

The demand picture going forward isn’t fully clear yet. In the U.S., diesel demand fell to a 21-year low last week and gasoline stockpiles swelled. These data points suggest that fuel consumption in the world’s largest oil consumer isn’t recovering as quickly as previously anticipated. While oil prices have rebounded rapidly since mid-April, the rally is faltering amid several headwinds. And while some demand has been faster to come back then expected, jet fuel isn’t likely to make a comeback anytime soon. As a result, the oversupply situation that I laid out seven weeks ago is where we find ourselves in today:

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.

That unprecedented situation in the oil tanker markets is still going strong, with 8-10% of the global tanker fleet still being utilized for floating storage:

What does this mean for tankers?

Ultimately, the spot charter rates of March and April were not likely to persist. At the time, economic activity had all but stopped and everyone was worrying about a different kind of curve. But with no way to economically shut down oil production, those in the market were scrambling to find somewhere to store all the unused crude and product that was coming to a nonexistent market. The future outlook was so unclear and pessimistic that the owners of these tankers were commanding rates that earned more cash flow per ship on a single route for 60-80 days than in nearly five years of normal operations.

But with the wild rides in rates over, tanker stocks have lost any momentum they may have had and continue to trade below recent their relative highs at the start of January:

Source: Bloomberg

On its face, this seems to makes sense. But even with though the astronomical spot charter rates that were being quoted in March and April have not persisted, what we have now are higher equilibrium rate prices for VLCC (“Very Large Crude Carrier,” 2M barrel capacity) tankers around $50k/d:

Source: Bloomberg

These levels are still extremely high relative to long-term averages, and significantly greater than breakeven costs for the more robust companies operating VLCC tankers. The general feeling among these operators and those who follow this industry is that average rates going forward will be higher than most believe. First of all, excess supply will take a couple of years to work through the system. The current unsustainable production cuts are nevertheless adding to the state of oversupply. Also, tanker operators will be able to be more selective about the rates at which they will be willing to charter going forward thanks to all the surplus income they earned over the first half of 2020. Last, but certainly not least, the lack of new tanker capacity and notable absence of private equity financing means that tanker supply will continue to be restricted. All of these factors contribute to a very favorable operating environment for the biggest shippers.

While the overall market has rebounded faster than anyone could have expected, this sector has been distinctly out of favor since the oil markets stabilized. Nevertheless, these companies have continued to earn ridiculous amounts of money, which can be used to pay off debt, buy back stock, or be paid out to shareholders as dividends. All three of these uses of excess cash will eventually have a positive effect on tanker company shares, many of which trade at significant discounts to their net asset value.

Markets are forward looking, but a whole lot of cash, right here, right now, has its own very special appeal. Tanker companies are about to show just how much money they made in the second quarter, and we think these sums will be hard for investors to ignore.