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Dropping Prices and Supply Glut Sends Oil Into Floating Storage At Sea

Dropping Prices and Supply Glut Sends Oil Into Floating Storage At Sea

There is so much surplus oil sloshing around right now, some of it is being stored on tankers at sea.

It's well known that there is a glut of oil in the United States because of a lack of infrastructure and the ban on exports. A surge in production, coupled with tepid demand, has caused prices to decline by about 13 percent since June: West Texas Intermediate (WTI) is trading at a price discount.

And those declining prices have led some commodity traders to decide that excess oil is better left at sea. There are now 25 to 50 million barrels of oil in floating storage, equivalent to more than two days’ worth of demand for the entire United States.

Related: With LNG Export Battle Won, Are Oil Exports Next?

The trend is not necessarily due to the lack of physical capacity to store oil, but largely because of the dynamics of modern day oil trading.

Spot prices for Brent crude, the international oil benchmark, have fallen below futures prices for the first significant period of time since 2011. By purchasing oil on the spot market, commodity traders can sell a futures contract on that shipment, and hold onto the oil at sea until the deal matures. Having paid a lower price – for example, around $98 per barrel as of mid-September – and selling a futures contract for delivery in October 2015 at $100 per barrel, the trader can pocket the difference when the deal is completed. The whole trend was nicely laid out in a recent Wall Street Journal story.

The margin may not seem like much, but according to the WSJ, it only takes a difference between the spot market and future market of about 70 cents in order to make a profit. The opportunity has not only attracted traders of physical barrels of oil, but also financial investors, who have jumped into the fray.

There are risks to this investment strategy. Storage costs and interest rates could rise, as the WSJ noted. Also, if spot prices decrease further in the months ahead, opening up a wider gulf with the futures price, traders will have missed out.

Another factor is the strength of the U.S. dollar, the currency in which oil is conventionally priced. A stronger-than-expected dollar will send oil prices lower. Moreover, as oil prices are notoriously volatile, it is unclear how long the price spread will last.

Why is there such a difference in price to begin with? For Brent, higher futures prices indicate that traders think that oil prices have slid far enough. Having potentially bottomed out, the markets apparently think that Brent will rise once again. For example, if OPEC cuts back on production, or the global economy picks up its pace of growth, prices would increase. This leads to futures prices settling at higher prices than what oil is sold for today.

Related: Western Sanctions Halt Exxon’s Drilling In Russian Arctic

But such a scenario is far from a certainty, given today’s global economic environment.

WTI is a different story. WTI was selling for $92.50 during intraday trading on Sept. 19. But WTI futures for delivery on Dec.19 – three months from now – is going for $86.75 per barrel. This is the reverse of the situation for Brent, and it suggests that the markets think that oil production in the United States will continue on its upward trajectory. Meanwhile, with flat demand and a dearth of infrastructure, oil will continue to pile up and bring down prices.

This phenomenon may seem odd, but it has happened before. In April 2009, more than 70 million barrels of oil were in storage awaiting future delivery. Of course, that was during the depths of the global economic recession, and spot prices at the time were trading for around $50 per barrel. The gap between the spot and futures prices was a wide one because the markets were relatively confident that the world would eventually dig out from the economic malaise.

But the return of significant storage for futures delivery suggests that the world is once again experiencing a period of oversupply.

By Nick Cunningham of Oilprice.com

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