After 30 years of investing, I’ve learned that three or four times each decade a market reaches a historic level, either high or low, that investors shouldn’t ignore. Right now, the most obvious opportunity is the historically low oil price. Investors seeking to profit from an oil price recovery have several avenues to consider.
By way of example, when the Australian dollar was trading above US$1.05 and the RBA announced it was uncompetitive, and that they would do something about it, it was the time to move Australian dollars into US dollar denominated bank accounts. I’d add the wheat price crash in 2000 and the world food price crisis, which peaked in April 2008, as well as the iron ore peak in 2011 to the list of market moves based on fundamentals that were unsustainable.
An oil price war (fought by oversupplying the commodity) between OPEC and non-OPEC producers, followed by the Coronavirus pandemic has produced a historic oil supply glut so great that land-based storage facilities are at capacity and oil is now being stored offshore on tankers carving figure-8’s in the ocean.
Consequently, WTI crude futures prices recently fell into deep negative territory. The circumstances are unusual and unprecedented, but oil is the most efficient re-balancing commodity given natural decline curves and finite reserves.
Short-term market inefficiencies that caused the collapse
In case you missed it, a couple of weeks ago WTI crude oil futures fell US$55.90 or 305.9 per cent to minus $37.63 per barrel. It was the largest price drop in history, and it was also the first time the commodity had traded below zero.
The short-term market inefficiencies that caused the collapse, in hindsight, were straightforward but they weren’t being predicted by many, if any. The COVID-19 pandemic, and the associated restrictions on economic activity, have caused a global collapse in demand for oil. At the same time, oil producing nations refused to significantly cut supply.
Meanwhile, oil futures buyers must take delivery of physical oil if they hold the contract at expiry. The United States Oil Fund LP (USO) is the largest crude oil ETF by assets and volume and is estimated to have held approximately 25 per cent of outstanding May-expiring contracts. The ETF however has no storage facilities and has no interest in taking delivery of oil. Given that just about all crude processing and storage facilities were already up to their eyeballs in crude oil, the only avenue for holders of the USO ETF to rid themselves of the obligation to take physical delivery was to pay buyers to take it off their hands. In other words, negative oil futures prices at expiry.
That negative prices are unsustainable – oil would cease being produced if producers had to pay customers to use it – is obvious and so it is reasonable to believe oil might have hit a historic and unrepeated low and the significant upside might be available to those that can position themselves, long-term, for a recovery.
Importantly the record low prices, if sustained for any length of time, adversely impacts the businesses of marginal producers, those whose costs bases are high. That means the massive supply glut will threaten hundreds of US shale oil producers with the prospect of Chapter-11 bankruptcy, and just as the US was celebrating its energy independence – perhaps the objective of Russia’s oversupply tactics to begin with.
Easing the supply glut
Low prices however might finally force all oil-producing nations to take radical steps to ease the supply glut. And there are already tentative signs this is occurring.
The Organisation of the Petroleum Exporting Countries and other large oil producers led by Russia, collectively known as “OPEC+”, have agreed to cut their combined oil output by 9.7 million barrels per day (bpd) in May and June, while some OPEC producers are talking of commencing cuts earlier.
Russia’s energy minister has asked for 20 per cent cuts from domestic producers, Saudi Arabian Oil Co. will cut production by 30 per cent to 8.5 million barrels per day, and with US$200 billion of North American oil-and-gas debt maturing over the next four years, an escalation in bankruptcies across US shale sector could further production cuts.
So how does an investor take advantage of a recovery from record low oil prices?
The first stop might be listed international oil producers like Exxon Mobil Corp., that can leverage their scale and diversified resources to turn a profit at much lower costs than smaller high cost base producers. According to analyst estimates, Exxon’s New Mexico properties are profitable at approximately US$27/bbl.
Oil ETFs listed in the US and Australia are another avenue for investors to investigate but investors need to be aware that historically they have captured between a third and a half of the major moves higher and this is partly due to the fact that investors give back some of the upside (lose) when futures contracts are rolled from the front month to the next traded month.
Of course, there are also Aussie players, which include, Woodside, Santos, Oil Search, Origin Energy and Beach Petroleum. Our research however results in some hesitation here. The underlying asset quality is relatively poor – generally Tier-2 and Tier-3 assets with less flexibility on the reinvestment required to maintain production. Moreover, most Australian oil companies have cash break-even points (pre growth-capex) of around $30/bbl, and most of these businesses are struggling to break even. Only Woodside is the exception with an estimated cash break-even of between $15 and $20/bbl). Given the current prices some oil price recovery factor is already being factored in.
Aussie producers also need to reinvest to maintain production regardless of the oil price. By way of example, Woodside has a capex wall of greater than US$6 billion, which represents about 50 per cent of its market capitalisation. Meanwhile, Santos and Origin require continual investment to maintain production rates given the nature of coal seam gas. As reserves deplete, the valuation declines independent of the oil price, while migrating towards lower-quality acreages with higher production costs.
Finally investors might also consider buying globally-listed tanker operators.
In the last few weeks shipping companies have reported signing three to nine-month contracts for offshore storage at up to five times break-even. According to EuroNav’s CEO, the breakeven for to operate its Very Large Crude Carriers is US$28,000 per day. This compares favourably to the six-month storage contracts it has been signing for about $80,000 per day.
As long as futures contracts in forward months trade far above current months, the differential becomes meaningful enough that it becomes profitable for companies and traders to lease out vessels, store the oil, and sell it at a future date. And with a quarter of the global VLCC fleet already locked up in floating storage, the longer the oil futures curve remains in steep contango, the more tankers will be employed for storage, placing a floor on tanker spot rates.
According to one research note, at current daily charter rates of around $200,000 to transport oil, a VLCC earns $70 million, which is a stunning return on a 10-year vessel worth about $50 million. And one which the owner has invested only about two fifths as equity. At current rates then, the tanker owners can make 350 per cent returns annually. Despite this, most tanker operators trade at about half their net asset value.
With a number of convenient avenues available through which investors might consider backing a recovery in oil, and with little doubt negative prices are an historic event, the only question may be the time frame required before a positive return is realised.