A recent US Energy Information Administration (EIA) came out with the Weekly Petroleum Status Report for the first week of February 2015 and highlighted the record levels of commercial storage filling US onshore tanks. Commercial storage reached 425 million barrels of crude oil, which accounts for 70% of total commercial storage capacity. Total storage came in at 1.1 billion barrels of crude, including the 695 million barrels of Strategic Petroleum Reserves (SPRs) held by the US Department of Energy.
The SPRs held by the US government are for emergency fuel requirements in the event of an unforeseen disaster, such as the polar vortex that chilled most of the East Coast in 2013-2014. With 691 million barrels of reserves, the US government has filled 95% of total SPR capacity, which is much lower than in January 2010 when SPR storage reached 99.9% of capacity.
US Storage: The Biggest and Best
Interestingly enough, total storage capacity in the US has reached record levels. Since 2010, 100 million barrels of commercial crude oil has been added to commercial storage units onshore. At the same time, 200 million barrels of commercial storage capacity has been added to storage infrastructure in the US. This increase comes as more storage tanks are built at transfer points, alongside refining operations, and along pipeline infrastructure. The added capacity since 2010 is the equivalent of 67% of China’s total commercial storage capacity.
The shale revolution in the US has created an onslaught of crude oil buildup within its borders, and infrastructure has been put in place to take on more crude storage. This has allowed the US to continue to store crude onshore while Asian markets are running close to full capacity.
Chinese commercial storage is almost 85% full, and similar Asian markets are looking for alternative ways to store their crude oil. Although most of this stored oil is for the use of refiners, there’s a fundamental change occurring in the market that has led to such a rush into storage: the contango market.
Contango Sends Storage Out of Whack
Unfortunate for the oil price, the current contango has made any hopes of a near-term return to previous highs in oil prices a pipe dream for the day traders. As crude oil floods a global market without enough demand to absorb additional oil production, the price of oil has plummeted to less than 50% of its value from a year ago. This flood of crude has created an interesting phenomenon in the crude oil futures market that was last seen in 2009.
In today’s market, the spot price of crude oil is lower than the future price, which is referred to as a market in contango. This can come from expectations of future growth in demand, a supply shortage, or a potential lack of storage capacity. In the current oil market, contango is developing due to a lack of storage capacity around the world. The future price of crude increases the further out you go in the future, because more value is placed on the ability for consumers to store that oil and use it in the future.
In terms of total days of crude oil supply, which is the amount of days it would take to deplete all commercial and SPR oil reserves, there continues to be record levels of crude stored even as prices plummet to levels last seen in May 2009.
The continued strength in oil storage comes as the steep drop in oil prices has led to a global contango market where traders try to cash in on buying cheaper near-term crude, storing the product, and reselling the crude at a later date. If the cost to store the crude is lower than the profit made selling the crude at a later date, then traders are able to make an arbitrage profit off the futures curve in the oil market.
How Contango Works
In the current onshore storage market in the US, a trader can lease out 500,000 barrels of tank capacity for an extended period of time… for example, let’s say a year. It costs the trader $0.50 per barrel per month to store the product onshore or $6 per barrel for a year. The current futures curve has an $11 spread between the March 2015 and March 2016 contracts. If we deduct the $6-per-barrel cost from the futures spread, the trader can generate a gross profit margin of 45%.
The black circle shows the current one-year profit from an onshore contango trade at a cost of $0.50 per barrel per month. If the profitability of the contango trade exists in US onshore oil markets, it’s likely profitable in other areas around the world as well, such as Asia.
Coming back to the storage capacity in Asian markets, the largest oil consumer is China, and its storage capacity is filling up. In 2015, the Chinese are hoping to relieve some capacity issues by building 30 million barrels of storage capacity by the end of the year. Netherlands’ Vopak will be adding 8.8 million barrels of storage; CEFC China Energy will be adding another 18 million barrels; and the Zhejiang Tianlu Energy Group will add the final 3.5 million barrels. For now, this isn’t enough to relieve the short-term squeeze on commercial crude storage capacity, and traders are finding unique ways to benefit from the widened contango spread in the futures curve.
Storing crude on ships is becoming more popular with traders in Asian markets as storage continues to deplete. There are 30-50 million barrels of crude oil being stored at sea in Asian markets in order to profit from the seaborne contango trade. Although floating storage is more expensive than onshore storage, last month the futures curve was in such a steep contango that many floating storage ships were turning an impressive profit while at sea. However, the volatility of floating storage has become most apparent in the contract month of April 2015, as the six-month contango spread has dwindled to under $5 per barrel from over $6.50 in contract month of March 2015. Although we may not see as much floating storage activity this month, if oil prices fall further and suddenly, the offshore contango storage trade could become reinvigorated. At this stage in floating storage, most ships that store crude oil are very large crude carriers (VLCCs) with 1.5-2 million barrels of storage capacity. Traders booking VLCCs for storage usually book the vessels on a time-charter basis, where the trader takes control of the boat while the company that owns the boat manages the day-to-day operations. The trader will pay the time-charter rate to use the boat, which is $34,000 per day, and pays all operating costs involved with operating the boat, including fuel, insurance, financing, and docking costs. Currently it costs just over $6 per barrel to book a VLCC on a time-charter basis for six months. The six-month spread on the futures curve is $4.85, which gives the trader a $1.00-$1.15 loss per barrel, represented by the black circle in this chart. If oil prices fall sharply, we may see the spread turn a profit like it did a month ago.
Only Storage Wins
The floating storage contango trade has started in areas that have a lack of onshore storage. China’s rush to increase onshore storage capacity is one indicator as to why the floating storage contango trade has become profitable in the East. As supplies from Russia, the US, Iraq, Iran, and Libya continue to increase, the futures curve is likely to steepen further and accentuate the immediate importance of storage on a global scale. To get ahead of this realization, investing in companies whose sole business is storage in the US market would allow investors to benefit from the global steepening of the futures curve in contango.
Around 90% of oil storage is held by oil and gas majors like Shell, ExxonMobil, Chevron, Total, and others. These majors usually use or, in some cases, lease out storage to traders who are looking to profit from the steep contango curve in the futures market. Most of the pure US storage plays are master limited partnerships (MLPs), which have two partners invested in the company. There is the general partner (GP) that manages and provides capital to the limited partner (LP), which then distributes a portion of before-tax earnings to unitholders of the LP to be taxed at their respective rates. For managing the LP, the GP is given a portion of the company's operating revenue in the form of an incentive distribution right (IDR). The IDR received is usually 2%-3% of unitholder distributions, and that rate usually increases as the amount distributed by the LP increases.
You can take the risk and directly invest in floating storage through VLCC carriers like Frontline Ltd., DHT Holdings, and Asian players like Vopak. However, the high debt levels of shipping companies and the weak spot market into Q2 may put these companies at a higher risk of underperforming. The safest way to play the potential global storage deficit for crude oil is in the MLP storage space. This will benefit US investors over Canadian investors, as Canadians will have to pay a 35% withholding tax when receiving unit distributions from MLPs in any Canadian trading account.
How Do You Make Money from the Oil Contango?
In this month’s Casey Energy Report, as well as in the March issue, we’ll break down the best way for US investors to play the contango.
The current energy markets are volatile, but a speculator must use volatility to his own advantage to build positions in companies that have suffered as a result of the current market correction.
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