Stonks n’ Rockets is a new series for your stock trading pleasure! In today’s episode Thomas George and Scott Willis look at the sustainability of the big bounce in the oil price.
Oil’s Big Bounce
The oil market had a massive rebound on Thursday, registering the biggest 1 day rally in history – with WTI up nearly 25%. The market had solid follow through today, up another 5% by midday.
Source: CNBC
The hope for investors is that OPEC can strike a deal to reign in the glut of crude oil on the market.
This Time It’s Different
Historically (last 20 years) every time there’s been a 1 day bounce of this magnitude from an oil bear market the oil price is always higher 1 year in the future.
However, this time is different. The travel devastation caused by the Coronavirus is unprecedented in history. The world has gone ex-travel and until we can get a handle on how long quarantines will need to be in place there is very little certainty in a typical V-shaped demand rebound from the bottom.
Source: National Geographic
Oil Supply is Overwhelming Demand
The global oil market typically operates at a rate where production and demand are within +/- 1-2 million barrels per day of each other which is only 1-2% of global demand.
This small buffer makes sense if any oil fields run into short-term problems,
This graph from the U.S. energy agency, EIA, illustrates this dynamic below.
Source: EIA
However due to global quarantine and the associated limited travel, supply is outstripping demand in the range of 50 million barrels per day – there has never been this level of oversupply in recent memory.
Any OPEC deal for 10-15 million barrels per day of reduced production would barely put a dent into this massive oversupply situation.
Why Prices Fall When Oil Storage is Full
Say I own an oil well that produces 4 barrels a day and I know three farmers who usually buy those four barrels from me for $50 each to run their tractors.
Well now these farmers only need three barrels a day.
For a while, I can offer all the barrels for $25 instead of $50 and one of the farmers will buy 2 barrels instead of one and store it in his personal storage tank, expecting he can use it later and save money.
But what happens when the farmer’s storage tanks are full and they literally have no use for that 4th barrel I’m trying to sell, regardless of the price I offer.
I still have four barrels coming out of my well each day and nowhere to store them so I absolutely have to sell all four.
Now I’m desperate and I offer them $10, maybe even $5 to take that last barrel off my hands.
This happens on a global basis when storage tanks fill up.
Prices may be down 50%, but if supply exceeds demand for too long, eventually the storage tanks fill up and prices have to fall another 50% or more to convince buyers to take all this excess oil from the sellers.
We are rapidly approaching this scenario.
Watch the U.S. oil storage hub in Cushing Oklahoma to see how bad the situation is.
Analysts estimate Cushing can store 85 million barrels of oil. We are currently at ~50 million.
If the storage hub hits capacity, oil prices in the U.S. are taking another leg down.
Cushing Oil in Storage as of March 27th
https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=W_EPC0_SAX_YCUOK_MBBL&f=W
The Tactical Trade is to Go Short Oil
We believe the market is baking in the full upside currently to an OPEC deal happening.
If the deal doesn’t go through or takes more time, we’ll see crude sell-off again. Additionally, when the market comes to the realization that a 10 million barrel per day cut in production is peanuts it’ll sell off again.
The ProShares UltraShort Bloomberg Crude Oil ETF (SCO) is the near-term ticker to buy. Avoid the opposite which is the ProShares Ultra Bloomberg Crude Oil ETF (UCO).
Source: ycharts.com
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