Another Wednesday, another giant build in U.S. crude inventories. U.S. oil in storage was expected to increase by 4.9 million barrels in the past week, but the actual result was an 8.2 million barrel increase.
In previous posts, I've detailed the importance of the futures market on crude oil storage levels but the focus has been on the commodity price. This time, the chart will show the long term, direct connection between the futures curve and storage levels, and also how the relationship broke down before the oil price's recent swoon.
The amount of stored crude is directly related to the futures curve, as I've detailed previously. In short, a steep futures curve (the 12-month future price is a lot higher than the one month West Texas Intermediate benchmark price, a relationship known as "contango") incentivizes speculative buying of physical oil and locking in the higher selling price through the futures market.
In the chart below, a rising black line line indicates a steeper futures curve. Between 1990 and late 2012, we find what we'd expect – total crude storage rises as the futures curve steepens (the speculative "buy now, sell at 12 month price" trade becomes more profitable).
SOURCE: Scott Barlow/Bloomberg
In 2013, the futures curve flattened significantly, actually going negative, but storage levels remain elevated. The reasons for the inverted futures curve (termed "backwardation") remain a subject of fierce debate, because it makes little sense. Why were holders of crude inventories willing to store oil instead of selling at spot price, in order to sell it at a lower future price?
Industry consultant Philip K. Verleger's theory, cited by the Financial Times in June 2013, was that ultra-low interest rates were to blame:
"Inventories of crude oil, at least in the United States, seem to have become one of the assets replacing treasury bills .. . there is a real prospect, then, that an end of [the U.S. Federal Reserve's quantitative easing program] could lead to liquidation of these assets and a significant crude price decline. Inventories have become an asset almost by default. Firms that hold stocks really have nothing else to do with their cash today. If they are lucky, their banks may offer them 0.25 percent on cash."
The end result was that oil storage climbed in an environment where more physical crude should have been hitting the market. As U.S. oil production surged – it has increased 30 per cent since Dec. 2012 – available storage facilities for oil quickly disappeared.
North American energy markets are now in a strange position. Intense contango is necessary because massive speculative funds are necessary to soak up the excess U.S. production. Meanwhile, oil production continues to increase (so far), which means a steeper and steeper futures curve is needed – either buy higher 12 month futures prices or a lower one month price. All the while, a huge supply overhang is building in storage, and the glut in supply continues.
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