I’m a macro guy. So you’re not coming to Credit Writedowns for trades. But this macro idea – that the US is not going to stay a net exporter of energy for long – came from a trade idea over a month ago. So, let me take you my thinking on this and how I arrived at my conclusion.
If you develop trade ideas based on my thesis, I will be happy to have helped. But, this more of a macro theme about Covid-19, demand destruction, energy companies, high yield and bankruptcy.
The Kupperman call
I got a Slack message on March 18 from Drew, my colleague at Real Vision. He told me to, “check the group. Harris Kupperman wants to come on RV we can do a skype interview with him or he could just be on the daily, thoughts?”
Real Vision had just shut down because of coronavirus. I had been in a hotel in New York until early March and then left for the DC suburbs where I am holed up now. Drew hightailed it to Lake Tahoe, where he is still holed up. And everything was virtual – no studio, no in-person interviews, no high-quality production value videos. Just Skype. The last in-person interview I did was with David Enrich – a full two weeks prior – on what a horrible lack of controls my former employer Deutsche Bank had.
I had never heard of Harris Kupperman, to be honest. But, it all started here. I called Harris and he was talking a mile a minute as I tried to gauge whether his trade ideas made any sense. Kupperman had been talking about tanker stocks since late last year. But now, equities were in freefall. And he was still talking about taking a long position. I was sceptical but I heard him out. And what he said to me made a lot of sense.
His view was that a Covid-19 induced recession would kill demand for oil. The numbers he gave me were a loss of 20 million barrels a day of oil demand for 50 days of lockdown followed by another 100 days of demand shortfalls of 10 million barrels a day as we left lockdown. In total, Harris was saying he expected 2 billion barrels of excess oil production in 150 days.
Where would it all go?
Harris said tankers. And he mapped out what that meant for the tanker industry and tanker stocks. His view was that – amid all the chaos and extreme pessimism – this was one sector that would do just fine. In fact, he thought tanker stocks would explode higher. And his thesis made sense. So, we booked him. Drew did the interview two days later and the interview went live eight days later.
The oil market and coronavirus
That interview was on my mind yesterday when the oil market imploded.
This massive front-end contango in WTI reminds me of a @RealVision video a few weeks back:
Opportunity in the COVID Crude Oil Contango https://t.co/9Epi5aij7m interesting look by Harris Kupperman
— Edward Harrison (@edwardnh) April 20, 2020
So, here’s how I am taking stock of the issue.
Kupperman was right. We have seen massive demand destruction. To give you a sense of the levels we’re talking about look at this tweet from Bloomberg’s Chief Energy Correspondent Javier Blas today:
DEMAND HIT: Spain, under coronavirus lockdown, is providing excellent oil demand proxy data on a **weekly basis**, allowing near real time analysis.
The latest figures for week to April 19 vs same week 2019:
Jet-fuel: -93%
Gasoline: -81%
Diesel: -55%#OOTT— Javier Blas (@JavierBlas) April 21, 2020
The International Energy Agency (IEA) is now projecting oil demand to be down 29 million barrels per day year-on-year in April, 26mbpd y/y in May and 15mbpd y/y in June. That’s worse than even Harris’ 20 million barrels for 50 days figure.
Oil storage and negative oil prices
So, what does all that mean? Again, it means Kupperman’s thesis about a build in oil and product supply and a lack of storage was spot on.
Last week, the US Energy Information Administration (EIA) reported that total crude and products inventories were up 27.2 million barrels. Each barrel has 42 gallons of product in it; so, that’s 1.14 billion gallons of oil and product. This is biggest weekly increase ever. And so, we now have a record 55-58 days of gasoline supply on hand.
A large data firm just put Cushing at 60.7 mb. At this rate, it should be full by June. TBH, I am trying to digest what is coming out of the shale patch w the TRRC meetings + talk of possibly paying producers not to produce, a la old farm support type support. AMAZING. #OOTT
— Patricia A Hemsworth (@phemsworth) April 16, 2020
This is the picture heading into the close of the West Texas Intermediate (WTI) May 2020 futures contract closing today. And so, what it has meant is that anyone who takes physical delivery – as they must do if they don’t close out their contract – must also find a place to store this oil.
With almost no storage available in landlocked Cushing Oklahoma – population 8,000 and the settlement point for WTI – you have a big problem.
So, yesterday, we saw a massive long squeeze, people unloading May 2020 futures contracts at any price before the expiry today in order to avoid taking physical delivery. That’s why WTI prices went negative for the first time in CME history.
The question now is whether this is an aberration or something more fundamental given the fact that the June 2020 contract is trading at more ‘normal’ levels, as are July, August and longer-term future contracts for oil delivery. In short: was this a one-off or a sign of things to come due to a massive oversupply of oil?
My conclusion: it’s fundamental, not technical.
The oversupply issue
First, let me refer back to a few ominous technical issues that are harbingers. First, there’s the CME Group that runs the clearing for WTI. Back on April 15, they issued a memo entitled “Testing opportunities in CME’s “New Release” environment for negative prices and strikes for certain NYMEX energy contracts” (PDF here). Their take in the memo:
Recent market events have raised the possibility that certain NYMEX energy futures contracts could trade at negative or zero trade prices or be settled at negative or zero values, and that options on these futures contracts could be listed with negative or zero strike prices.
Were this to occur, all of CME’s trading and clearing systems would continue to function normally. Support for zero or negative futures and/or strike prices is standard throughout CME systems.
Translation: CME warned us to be ready for negative prices a week ago.
The second sign came from a regulatory filing on Thursday:
The $3.8 billion U.S. Oil Fund, which accounts for about 25% of all outstanding contracts in the most-traded West Texas Intermediate crude futures, said it will alter some of its position, citing market and regulatory conditions.
The exchange-traded fund, which normally holds WTI futures for the nearest month, will now move 20% of its contracts to the second-traded month, as an unprecedented global supply glut pushes down prices for contracts near their delivery dates. The change takes effect Friday and will be in place until further notice, it said in a filing with the U.S. Securities and Exchange Commission.
Kevin Muir pointed out yesterday in his MacroTourist newsletter that “The USO administrator started rolling out of the May contract on April 7th, and was finished on April 13th.” So clearly this is a sign that USO sees the negative price on the front month contract as a potential recurring phenomenon and has decided to move a portion of the ETF holding out.
When June delivery rolls around Cushing will be full again and we’ll have the same problem. That’s what I anticipate. And the June 2020 contract is imploding right now, trading at $15.64 as people realize what’s happening. Even Brent is trading at $20.66 as I write this. It’s an absolute slaughter out there.
The issue is oversupply. And none of this will go away until supply and demand are in balance – which means supply means to shrink some 20-25 million barrels per day.
That can’t happen without 1. a continued collapse in oil prices and 2. massive shut-in wells and bankruptcies.
Cartels and the US shale guys
Here’s an interesting tidbit from the Great Depression from a recent article on how cartels work:
The Railroad Commission of Texas (RRC) will hold a hearing tomorrow morning to discuss the possibility of prorationing Texas oil production after receiving a petition from Pioneer and Parsley…
What does history tell us?
History shows us that regulation without the ability to monitor or enforce creates chaos and wastes taxpayer money. The discovery of the East Texas oilfield in Rusk County, Texas, in 1927 led to continuous production increases until oil prices collapsed to 10 cents a barrel. In an effort to raise prices, the RRC issued its first proration order for the East Texas field on April 4, 1931, effective May 1.
However, the order created unrest and violence in the area. Producers refused to comply and continued to increase production. In response, the Texas legislature passed the Oil Conservation Act in a special session called by the governor. However, proration was challenged in federal courts and a three-judge panel sided with oil producers against the Commission.
On August 17, 1931, Governor Sterling, claiming insurrection, declared martial law in the East Texas Oilfield, and asked General Jacob Wolters to lead a force of Texas National Guard and Texas Rangers to shut-in all wells to preserve order and enforce the RRC rules. Once production was under control, Sterling called a special session in 1932 to approve the Market Demand Act, which gave the RRC more powers.
However, all 19 proration orders in1932 were successfully challenged in court. Such stories are not limited to Texas. Oklahoma also resorted to use of the National Guard to remove oil producers from private oilfields and shut down wells in order to enforce state regulatory orders.
Conclusion: You’re not going to get people cutting voluntarily when doing so would bankrupt them. They are going to produce flat out because they have bills to pay. And when everyone is oversupplying, the price of oil plummets until the weakest producers hit the wall. That’s what’s about to happen to US shale.
This could ignite another round of bankruptcies among US energy producers, which have already had a spate of recent insolvencies. Investors are demanding 9.1 percentage points in extra yield to own energy junk bonds vs non-energy junk, even post-Fed intervention in credit markets pic.twitter.com/pEZIXHIYqg
— Lisa Abramowicz (@lisaabramowicz1) April 21, 2020
I don’t care if the Fed is buying fallen angels and some junk ETFs. This isn’t going to prevent these shale firms from going to zero. Chesapeake, a large US shale pioneer, hasn’t produced a profit in a decade. It’s simply not sustainable.
My View
The oil and gas industry shed nearly 51,000 drilling and refining jobs in March, a 9% reduction that is likely to get worse as futures prices fell into negative territory Monday.
March’s job losses rise by 15,000 when ancillary jobs such as construction, manufacturing of drilling equipment and shipping are included, according to BW Research Partnership, a research consultancy, which analyzed Department of Labor data combined with the firm’s own survey data of about 30,000 energy companies.
“We’re looking at anywhere between five and seven years of job growth wiped out in a month,” Philip Jordan, the company’s vice president said in an interview. “What makes it sort of scary is this really is just the beginning. April is not looking good for oil and gas.”
We’re about to see a massive wave of defaults, bankruptcies and liquidation in the shale sector. And unlike last time in 2015-16, these guys aren’t coming back. Shale oil wells have huge decline rates. And so, once those wells are dry, there will be little to no incremental capital investment in US shale.
Banks, which will be hemorrhaging losses from other parts of the economy won’t have any capital to take flyers on energy companies. High yield investors, burned by a default wave, won’t step up either.
When this is over, the US is not going to be energy independent. US shale is finished as a swing producer for years to come.
And so, by early 2021, with the economy potentially recovering from its Covid-19 malaise, the story will turn from demand recovery to a realization of massive supply constraints. That’s good news for the majors which will survive this scare.
But, remember, if we have another Great Depression, all bets are off. The oil bust will endure. And the pain will be more widespread.
As always in the oil patch, first the boom, then the bust, then the next boom.