Heed the Message of the Crude Oil Forward Curve

By John Banks

To quickly recap recent commentary, we explained on April 17 why the oil price could go negative. And then, on April 23, we explained why negative pricing came so quickly.

Some of you wrote in to ask, “Who was buying oil at the negative lows? Were they taking delivery?”

It’s possible the big global commodity houses were buying to take delivery.

Outfits like Vitol, Trafigura, and Glencore specialize in trading not just paper commodities, i.e. futures contracts and derivatives, but the actual, physical stuff.

These are the guys with the size, financing, and logistical know-how to actually book a VLCC (very large crude carrier) supertanker, at a rate of $120,000 per day or more, and move two million barrels of oil into it.

For those with the means to actually move and store oil — and it’s notable that storage is close to full, but not 100% there yet — getting paid $37.63 to take delivery may have been worth their while.  

It is also likely, however, that a majority of the expiring May contracts were closed via offset of buyers and sellers, with no delivery assignments taking place.

If a futures contract is closed out via offset — meaning that an initial buyer and seller match up with each other — there is no end-of-contract delivery because the contract is extinguished (think of how a loan is extinguished when the borrower makes the final payment).

As a result of this, a majority of futures contracts — even the ones with physical delivery terms — settle out by way of cash changing hands.

Then, too, many types of futures contracts (though not for crude) are cash-settlement-only in the first place, which means there is no “delivery” at all other than cash payment.

And so, while physical delivery arrangements at negative pricing may have occurred, it is more likely that crude oil players who were already short the futures contracts — either for hedging purposes or because their analysis had made them bearish — had simply stepped back from the market on April 20, watching prices plummet and playing a game of “how low can this go” before finally deciding to cover.

It’s all a bit wonky, and those who hold out hope things are “not that bad” economically might be tempted to emphasize this.

If oil’s negative pricing adventure was down to arbitrage trades gone bad and an expiring futures contract, in other words, perhaps crude oil’s economic message is not as gloomy as it seems. 

Alas, no.

Crude oil’s economic message is more than just bearish at the moment — it is full-on Kodiak Grizzly.

To get a sense of the oil outlook, don’t look at front-month contracts. Look at the back-month contracts.

Because crude oil is arguably the most important commodity in the world, crude oil futures have monthly expiration dates stretching out years into the future. The “back months” are the contracts that expire multiple months away, or even multiple years away.

This means you can look at, say, the WTI crude futures contract for May 2021 to see where crude is priced for physical settlement a year from now, or the contract for May 2022 to see where it is priced two years from now.

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The “forward curve” for crude oil — a graph plot showing the pricing of back-month contracts — is thus useful because it represents the market’s best estimate for how crude oil will price out, relative to supply and demand changes, far into the distant future.

As of this writing, the back-month futures contracts for WTI crude are below $40 a barrel — all of them — all the way through December 2023.

Think about the implied message there.

In terms of how the economic future will play out, and the impact of such on global demand, the crude oil forward curve says it will be January 2024 before we see WTI crude above $40 again.

The U.S. oil and gas industry cannot survive if WTI crude stays below $40 per barrel that long, or even half that long or one-third that long. The hardiest players might make it — the well-capitalized oil majors, the big oilfield servicers, and a handful of others — but the rest would go extinct.

On April 7, the Kansas City Federal Reserve released its latest quarterly energy survey. Here were some of the survey’s “selected energy comments” provided by regional oil and gas producers:

“We cannot continue producing oil below the cost to produce it. Prices must go up, but there is a world-wide oversupply keeping prices down.”

“I don’t know of any companies that can operate profitably at that price ($40/bbl oil). The ones that stay solvent have cash reserves, refining, or other revenue streams to keep them solvent.”

“Long term, $40 is not enough. Some will be able to survive but many/most will not.”

The White House will bend over backwards to try and save U.S. shale, and the U.S. oil and gas industry in general, from oil-price-related insolvency.

It will do this for political reasons, not economic ones. The state of Texas is dependent on energy-related jobs; 2020 is a presidential election year; and Texas is the country’s third-most-populated state. 

But if the forward curve holds, any attempt to save the U.S. oil and gas industry will be good money thrown after bad (U.S. shale has already burned up hundreds of billions worth of investor capital).

In terms of government rescues, it is one thing to help an industry get through an unprecedented, but temporary demand shock. It is another thing to see non-viable pricing and a likely industry glut stretching out for years, as far as the eye can see.

The strong impulse of the White House to try and rescue the U.S. oil and gas industry — no matter how futile the attempt — may also explain why the price of XOP, the oil and gas exploration ETF, actually rose in the same week oil went negative.

Though the crude oil forward curve is forecasting a prolonged multi-year recession, or possibly even a depression, stock investors buying oil and gas companies are hoping for an injection of sweet, sweet billions by way of politically motivated stimulus.

We think this is too clever by half.

Anyone buying energy stocks on a combination of economic optimism and political expectation will need to be very nimble in their timing, lest they get crushed (in the same way bottom-callers in the oil market itself were crushed).

It is also notable how the oil price — and the forward curve in particular — is in stark contrast with the hopeful message of the stock market.

In an April 21 TradeSmith Decoder model portfolio update, we wrote the following:

“The oil price is a harbinger of just how far from “normal” we are — and just how much this idea of bouncing back to normal — or having any kind of V-shaped recovery at all — is a fantasy.

Then, too, it isn’t possible for oil and stocks to both be “right.” One of the two is very out of whack. Either the oil price should rationally be much higher, or stock valuations overall should be much lower, given the backdrop of what is going on in the world.

We think the oil price is the better “tell” — and stocks will follow the oil price downward.

That is what happened in 2008 too, by the way. The oil price peaked in July 2008, and began to plummet well before stock prices collapsed.” 

Stock market investors, mutual fund managers, Wall Street analysts, and cheerleading politicians can afford to put a glossy spin on things. They can paint a sunny picture without much negative consequence — and are often incentivized to do just that.

The commercial players in the oil market, in contrast, have to be hard-nosed and realistic, because the crude oil forward curve is not just a string of casual guesses as to what the future price of oil should be.

The prices that create the forward curve are active contracts that can be entered into now, today, for actual physical delivery. Given this direct tether to reality, anyone who puts gloss or spin on a physical commodity market, with real dollars at risk, is at risk of losing a fortune.

For these reasons and more, we’re inclined to believe the forecast implied by oil, not the S&P 500 index. And if the forward curve is accurate, much of the oil and gas industry is facing an extinction event.