The futures curve is allowing the price of West Texas Intermediate crude oil to defy the laws of supply and demand, but it may not last long.
The current upward sloping shape of the WTI futures curve is helping support the crude price by making the process of storing oil and "selling forward" profitable. Large trading firms buy crude at the spot price and agree to sell it at a higher price for delivery in a year's time or longer. The difference between the spot price, and the agreed-upon future price, minus the storage costs, forms the trading firms' profit.
This week's chart shows the current (upward sloping) WTI futures curve and the (downward sloping) curve from 12 months ago. In 2014, the futures curve provided no motivation to buy oil to sell at a later date. The $98 (U.S.) per barrel spot price was much higher than the price to sell in the future.
The current futures curve allows large scale traders to profit from storing crude. For example, oil can be bought at the spot price of $47.12. The owner can then immediately agree to sell it, using a futures contract, for delivery in June, 2018, for a price of $64.65 per barrel. The storage costs, according to Citi analyst Richard Morse, can range from 25 cents per barrel (for salt cavern storage) per month to $1.25 per barrel (tanker storage) monthly. The per barrel profit is determined by the selling price of $64.65, minus the original cost ($47.12) and the fees to store.
The profitability of this storage trade is vital for the commodity price in the current market. The massive build in U.S. crude inventories reflects significant oversupply. The traders and speculators involved in the storage trade are providing an important source of demand for physical oil, and this is supporting the spot commodity price.
All of this would be perfectly fine if the Americans weren't running out of facilities to store crude. As Mr. Morse writes, "If producers don't shut in enough production and global over-supply persists in the first half of 2015, the crude will have to go into storage somewhere. And as cheaper storage builds and the cost of storage rises, [near term] prices may have to fall to keep storage attractive."
In other words, storage costs will rise as it becomes more scarce. If these costs climb high enough to make the storage trade unprofitable, demand for oil at the spot price will decline – nobody will buy oil to store and lose money. This would put downward pressure on the oil price.
The rapid increase in the amount of stored oil is a clear indication that there is more crude being produced than necessary for short term use. Oil demand through the storage trade is helping support the commodity price at levels higher than the current glut would normally justify.
Widespread North American production cuts would obviously alleviate the oversupply problem and ease the pressure on oil storage prices. There are, however, few signs so far that production has slowed. Despite the well-publicized decline in the number of operating oil rigs, U.S. oil production has climbed 11 per cent in the past nine months to 9.4 million barrels per day.
The pace of U.S. crude production growth has slowed and there remains hope that further cuts will help end the period of excess supply. But until that happens, investors should watch U.S. oil storage levels closely, and reduce holdings in energy investments if a shortage of storage space occurs.