COMMENT: Oil price in dire Straits as demand for floating storage surges

COMMENT: Oil price in dire Straits as demand for floating storage surges
Low demand is forcing oil to be put into floating storage.
By Kim Iskyan of Truewealth Publishing June 15, 2016

Recent weeks have been sunny ones for the price of oil. Since a mid-February low of $26 per barrel, the price of oil has nearly doubled. And in the last couple of months, prices have gained over 35%. Now, at nearly $50 per barrel, both WTI (West Texas Intermediate) and Brent prices are at levels last seen in October 2015. 

Russian assets have rallied accordingly, since Russia’s economy is heavily dependent on oil. The RTS Index is up 47% since its January lows. The ruble is up 21% from its recent lows. On the surface, happy days – or at least less-glum days – are back.

As such, many analysts are now excited about the prospects of a further crude oil rally. Some are even predicting a return to $100 per barrel oil. They argue that the global supply glut, which has been keeping prices down, is unwinding. This could lead to a supply/demand rebalancing. And they are pointing to a handful of severe global supply disruptions to support their views.

First, wildfires have been raging in northern Alberta, Canada – the country’s most important oil producing region – disrupting crude production. As of the end of May, the wildfires were responsible for taking about 1mn barrels per day (b/d) offline. That’s 40% of the country’s total output, and slightly more than 1% of total global supply. This supply reduction has helped support oil prices.     

In the last few weeks, militants have been attacking key oil facilities in Nigeria – Africa’s biggest, and the world’s sixth-largest, oil producer. This has also been roiling oil markets, resulting in a 1.1mn b/d supply reduction. What’s more, the militants have promised that more attacks are coming.

The US’ weekly operational oil rig count fell to its lowest level in almost seven years in May. This indicates that US oil production has been declining as well. Its oil stockpiles have fallen three times in the last four weeks, and this has also contributed to the recent oil rally.

But if you think oil prices will keep heading higher, you might want to think again. And you should look at what’s happening in the Straits of Malacca to get a more complete picture of the world’s oil supplies.

The Strait dope

The Straits of Malacca are just off the coastal waters of Singapore and Malaysia. They are a vital stretch of water connecting the Indian Ocean to the Pacific Ocean and South China Sea. Oil heading to China and Japan from the Middle East, for instance, passes through the Straits. The US Energy Information Administration (EIA) estimates that 16% of total global oil supply passes through the Straits every day – that’s over 15mn barrels of oil. 

Except not all of it is just passing through right now. There’s been a huge build-up of tanker ships holding millions of barrels of oil parked there. In late May, Reuters reported that 47.7mn barrels of oil was in storage on tankers in the Straits of Malacca (which is about half of the world’s global daily crude supply). This is the highest level in five years, and has been consistently rising in recent weeks. (And a glance off the East Coast Parkway suggests that there does seem to be more tankers in the water than usual.)

Normally, oil traders could decide to store oil offshore because there are profits to be made. This can happen when the oil futures curve is in contango. This means that the spot price of physical crude, or the price to buy a barrel of oil today for delivery today, is lower than the futures price – which is the price at which a barrel of oil can be purchased today, but only for delivery at a future date. When the opposite is the case – when the spot price is higher than the futures contract price – the market is considered to be in backwardation.

So if the futures price is sufficiently higher than the spot price, a trader can buy actual crude oil and keep it stored in an oil tanker. Then, once the higher future price is locked in, he will deliver the oil in storage to the buyer at a later date. For this to be profitable, the futures price would have to be higher than the spot price plus the cost of storage.

But this is not what is happening in the Straits of Malacca at the moment. The contango is nowhere near strong enough for traders to make money by buying and storing this amount of oil.

So why is so much crude in floating storage if no one is making money doing so? Because there aren’t enough buyers for all the oil at these prices. The low demand is forcing oil to be put into floating storage, while the market looks for other places to store the unsold crude.

Floating storage would not normally be used if the oil could be stored somewhere else. But there is nowhere else to store all the extra oil. In fact, banks are now reporting that there is a spike in interest from oil traders who need money to fund their floating storage requirements.

So, this oil may stay on tankers until there are more buyers. And there may not be any buyers until oil prices head lower.

Global glut

Singapore – the major port on the Straits of Malacca – seems to be the epicentre for this growing oil glut. But it’s becoming a global phenomenon. BMI Research, a financial market analysis firm, calculated that the world’s total floating storage increased by just under 20% from the beginning of 2015 to the beginning of 2016.

For example, on the US Gulf coast, another major oil-producing region, oil stocks rose by 18% from the beginning of the year to May. An increase in oil stocks means that there is too much oil, and the global supply glut is likely far from over.

And China has been importing almost 1mn b/d more than they need, according to one commodity research firm. In the first three months of the year, China was storing about 787,000 b/d. According to one estimate, China has 135mn barrels of oil in storage. But its storage capacity is about 155mn barrels, so this could be maxed out within a month.

The supply disruption problems in Nigeria and Canada are only temporary. Once they are resolved, another 2mn b/d will come back online. And when China maxes out its oil storage capacity, that will only add to the world’s oil oversupply.

So, those who are saying oil will continue surging higher may have to adjust their forecasts. There is still plenty of oil floating around.

Truewealth Publishing is a Singapore-based independent investment research company. Click here to receive the Truewealth Asian Investment Daily, a free e-letter that takes the mystery out of finance and investing, in Asia and around the world – and which will save you time and make you money.