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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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The Best Risk Free Return In Town

The Best Risk Free Return In Town

Complaints from retirees about the meager returns offered by savings these days are legion. There is little that most retirees can do about this situation without taking on more risk. But the low interest rate environment is leading to fantastic risk free returns for another group; oil traders.

Since the lifting of the oil export ban three months ago, U.S. crude shipments have done the exact opposite of what many might have expected – they have slowed considerably. The U.S. is importing large amount of oil today – imports are at a 3 year high – all while exports remain very low. This phenomenon is largely driven by the opportunity traders who have to earn big profits with minimal risk. Related: This Is How Oilfield Services Are Surviving Low Oil Prices

Traders and producers all expect oil prices to eventually rise again. As a result, forward contract prices on oil are considerably higher than spot prices. WTI for delivery 6-8 months from now is trading for anywhere between $3 and $5 more per barrel more than current spot prices. Traders can sell a forward contract and buy the oil on the spot market to capture this differential. Then, they simply need a place to store the oil and insurance to cover the carry risk. Despite concerns about the U.S. running out of storage capacity, new storage has been being built at roughly the same pace that it is being filled. Storage costs per barrel are running at roughly $0.50 to $0.60 a barrel in many areas at present. The result is a small but nearly risk-free profit for traders on every barrel.

That low cost of storage is driven by the low interest rates that storage companies are able to borrow at. With storage construction costs around $50 a barrel, storage companies are creating new storage as fast as oil companies and traders can fill the existing space. That trend will likely continue going forward as the Fed seems to be in no hurry to raise rates given the economic headwinds battering the global economy. Related: Will China's Slowing Economy Stall The Silk Road Project?

The strange situation of oil traders being paid to store crude is being exemplified on a variety of fronts. VLCCs, Very Large Crude Carriers, are being used for storage all around the world, which has helped partially revive the stock prices of moribund firms like Frontline and other crude shippers. Buying and storing oil has become a hot trade in an otherwise awful oil market and its one of the few risk-free opportunities out there – granted it requires some knowledge of the storage market and a little legwork. The four-week average of imports is roughly 10 percent higher than it was a year ago, and it has been that way for weeks now as a result of this trade.

For U.S. traders, it makes more sense in many cases to buy and store domestic crude, which is already near available storage facilities, than it does to hold imported crude. The surge in imports is being driven by demand from refiners who see a price opportunity. U.S. refiners are well equipped to handle heavier API oil like that from Mexico and Venezuela. The oil is cheaper than West Texas Intermediate, providing a more attractive crack spread for producers and the refiners that have spent years upgrading their equipment to handle heavier grades of crude. Related: Are We On The Right Track To An Oil Price Recovery?

After the U.S. overturned the crude export ban, WTI has risen drastically in price against Brent which in turn has made imports more attractive than domestic production giving rise to the strange situation the country finds itself in today.

As long as this difference remains narrow and WTI is close to parity (or even above Brent), it’s likely that U.S. refiners will keep buying foreign crude, and U.S. crude will keep entering storage. It’s not every day that free money bubbles up out of the ground after all.

By Michael McDonald of Oilprice.com

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