Author: Brynne Kelly 8/01/2022
Members of the OPEC+ alliance are scheduled to meet this Wednesday to decide on September output quotas for the 23 nations in the group.
The importance of this week's meeting is twofold:
The Declaration of Cooperation by the OPEC+ group that was designed to slowly and methodically bring production back online is reaching its conclusion and by the end of August, production will be fully restored to pre-pandemic levels, and
Decisions made from here could signal how OPEC+ intends to operate going forward, making it a landmark meeting in that regard. One that will give us some clues regarding geopolitical cooperation going forward.
Wire reports so far indicate that OPEC+ will likely leave production as it is or raise it just slightly for September.
The US has also been dipping into it's reserves to add more barrels to the market. This was a measure taken by the Biden administration to keep a lid on oil prices and out of frustration that OPEC+ wouldn't restore their production to pre-pandemic levels fast enough. This began in December, 2021 after Biden had cobbled together a global stop-gap of SPR drawdowns until OPEC came back to their "promised" levels.
President Biden tweeted to that effect Nov 27th:
"This week, we launched a major effort to moderate the price of oil — an effort that will span the globe in its reach and ultimately reach your corner gas station. It will take time, but before long you should see the price of gas drop where you fill up your tank."
What have gasoline prices done since then?
A quick review of gasoline futures since the US began releasing reserve barrels at the end of 2021 through now (red box below) show that prices have indeed retreated from their highs made earlier this summer, but remain well above the cheap prices we had grown accustomed to in the preceding 5 or 6 years.
How is this filtering through to the back of the market (2023 and beyond)?
Since the initial announcement to release SPR barrels starting in December 2021, the back of the gasoline curve has shifted higher by almost $1/gallon (red line vs gold line below), showing only a moderate pullback over the last few months (green line vs gold line below).
The problem is that both the guaranteed monthly supply increases provided by OPEC+ and the US releasing reserve barrels are coming to an end. Again, this puts a spotlight on the upcoming OPEC+ meeting for a variety of reasons, not the least being the lack of real production growth.
We have stated previously: the 1 million barrels per day of SPR inventory releases were 'making up' for a lack of US production growth. Yet, we are still not seeing material production increases by US producers.
Things are coming to a head. Monthly production increases from the original OPEC+ agreement are ending at the same time the releases of US SPR inventory are slated to terminate. Yet to date, US production has not recovered. It's no wonder then that backwardation in oil markets has continue to remain 'sticky' even as outright prices have moved lower.
Nothing has been able to move the dial higher yet, so to speak, on crude oil inventory levels, and this is contributing to elevated risk premiums in the front of the market.
The stop-gap measures that carried us through the last year and a half are set to end with no real clarity on what will replace them. Perhaps the backwardation remains sticky even though prices have moderated somewhat, due to this lack of clarity as the deadline approaches. Perhaps then, the backwardation is in part an uncertainty principle at play.
This led us to ask the question 'how will inventory be replenished to more normal levels in a backwardated market and where is the incentive to do so?'. These questions have plagued the market and led to volatility in calendar spreads.
While the one-month calendar spreads shown above have retreated from their recent spike highs, they still remain elevated. Some believe that the market needs to move into contango to entice storage owners to hold more barrels. Possibly.
When the forward yield is negative (the percentage by which the future price is lower than the spot price) traders should be selling physical and buying forward like mad. By doing so, they earn interest on cash, save storage costs, and lock-in an easy profit buying back their oil for less than than what they sold it for. Very quickly, all the selling should create a glut of physical oil, driving down spot prices, while the buying forward drives up future prices, until the yield is positive and sanity is restored. Yet this isn't happening yet (unless you consider the sale of SPR inventory an economic decision based on the above theory). How can we balance the selling created by negative forward yields with the need to build inventory?
To do this we turned to the oft-forgotten concept of Convenience Yield.
Convenience Yield Revisited
A convenience yield (CY) is an implied return on holding inventories. It is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints. This makes it possible for backwardation to be observable.
To clarify in trader-speak the 3 main components used to infer convenience yield (taken against the level of backwardation in the market) are:
cost of carry (storage costs)
cost of money
cost of insurance
Storage and Insurance are relatively small
Storage and insurance costs are somewhat less discoverable than the cost of money as they are unique to each individual player. However, given current price levels, monthly storage costs as a percentage of nominal prices are negligible (CME Loop Storage futures are currently trading at $.05/bbl per month). The cost of insuring oil stored in inventory at these price levels is something that is less discoverable, and therefore left out of the analysis, but something that is worth a further deep dive.
Money is the Big Component
That leaves us with the cost of money. As was reported last week, rates continue to rise and are a key component in the calculation of convenience yields. All 3 components listed above are compared against the level of backwardation in the market to determine the implied convenience yield.
Toward that end, we calculated the convenience yield implied in the spread between continuous spot prices versus the relevant continuous futures contract 3 months out (Quarterly seemed a good place to start the experiment). We plotted this against EIA inventory levels below:
The marginal convenience yield is expressed as a percentage of the spot price (i.e. not in monetary value per unit of commodity) accruing to the owner of a spot commodity.
The convenience yield is inversely correlated to inventory levels as one might expect
Noted in the chart above, current convenience yields (yellow line = 3-month convenience yield) are lower than they have been at any other time in history when inventory levels (black line = US EIA Crude Oil Inventory) were even close to this low. Put another way. Convenience yields are not making post 2005 highs despite inventories making post 2005 new lows. As a side note: From Jan 1986 through May 2008, oil futures have reflected a convenience yield of 8% per year on average.
What Drives CY?
In a nutshell, the level of backwardation vs the cost of money. Convenience yields grow as the price differential between near-term and further-out prices becomes more volatile.
Suppose that the current convenience yield is about 8% and three month interest rates are about 2%. Then a one-year futures contract should be about 6% cheaper than spot, and a four-month-out contract should be about 1.4% cheaper than a one-month-out contract (reflecting 3 months of storage). Let's say that at the end of May, the 4-month-out contract was in “backwardation”, but was only 0.5% cheaper than the 1-month, still too expensive given the convenience yield. Investors could have earned (on an annualized basis) about 3.6% more than the risk free rate (about 5.6% overall) buying high and selling low, but enjoying the privilege of storage and the 'convenience' it affords to take advantage of 'event-risk' spikes in prices exacerbated by low inventory levels.
So why aren't today's convenience yields leading to more oil held in storage? Part of it has to do with the US intentionally draining the SPR. Looking at Commercial inventories only, we can see that they have been ever so slowly increasing this year.
Perhaps the rising convenience yields demonstrated earlier ARE having an impact on commercial players decisions.
This is something that requires further vetting, but could suggest that convenience yields have reached a level that makes storing oil more attractive. If so, we will see this bear out in future EIA reports of commercial inventory levels. It could be that commercial players are getting the benefit of higher convenience yields due to the overall future uncertainty created by the extreme drawdowns of the SPR.
A more macro quantified way of looking at if spreads are valued properly is needed
Due to frustration with OPEC dragging its feet on increased production in 2021 President Biden announced that Oil prices should move lower based on somewhat coordinated global SPR releases
We are one month away from the SPR tap being turned off while OPECs production increases are also slated to cease growing
Spreads remain sticky ( but admittedly more volatile recently) even as flat price has dropped somewhat. Why?
Convenience yield at first glance shows they are lower than they were last time inventories were this low. Why?
Is the CY undervalued or overvalued on this basis and trading experience
We may find out once September rolls around even if nothing changes event-wise
The convenience yield cannot be calculated directly; like implied volatility, it can only be inferred by the deviation of the actual contract value from the value calculated without considering the convenience yield. And like implied volatility, convenience yield changes continually. This is worth keeping an eye on.
EIA Inventory Recap - Week Ending 7/22/2022
The EIA reported a total petroleum inventory DRAW of 14.30 for the week ending July 22, 2022. Commercial inventories posted a DRAW of 4.60.
YTD total petroleum EIA inventory changes show a DRAW of 137.70 through the week ending July 22, 2022.
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to flounder while backwardation in the market persists.