Oil investors, beware of contango

Oil Investors macro flash notes.JPG
36 days ago (22 Apr 2020)  |  

The price of a barrel of WTI oil fell into negative territory earlier this week. This anomaly is clearly unsustainable and should discourage production, thus supporting prices. In this Macro Flash Note, GianLuigi Mandruzzato looks at different ways to profit from higher oil prices.

The oil market is under stress. Despite OPEC+ agreeing to reduce supply by almost 10 million barrels per day (mbd) starting from May, the front month West Texas Intermediate (WTI) oil price future recently turned temporarily negative on 20th April. Downward pressure on prices reflects a range of factors. Production cuts have not yet started while demand is about 30mbd lower than normal due to Covid19 outbreak containment measures. The need to store unconsumed oil has saturated inventory capacity, such as that in Cushing, which is the reference for oil futures contracts. Futures contracts are settled with physical delivery based on the owner of the contract on the expiry date, which was 21st April for the front contract. Traders unable to store the oil corresponding to their long positions liquidated them unconditionally, pushing prices below zero.

Current low prices are unprofitable for all producers, suggesting supply will fall beyond that agreed by OPEC+. Meanwhile, demand will rebound as Covid19 containment measures are relaxed. This rebalancing of the market will support prices. Our model predicts the WTI price will rise by end 2020 (see Chart 1). However, it may be hard for investors to benefit from it.

Chart 1. WTI price model and market forecasts (USD/b)

Source: Reuters Eikon, Refinitiv and EFGAM calculations as at 22 April 2020.

This is because the market is already discounting a strong price increase. Futures contracts predict that the price of WTI will rise to USD21.5pb in July 2020 and USD29pb in December 2020 (see Chart 1). Technically, the oil market is in contango, i.e. the oil price on futures contracts with longer maturities is higher than the spot price.1 For investors it means they will only earn money if the price at maturity is higher than today's futures contract price. In the case of the July contract, if the price were to rise to USD19pb, a long oil trade commenced today would suffer a loss of 12% despite an increase of about 27% over the price of the first current contract, equal to USD15 pb at the time of writing.

This is because as the expiry date of the first contract draws closer, positions will be rolled over to the next contract. If, as is currently the case, the price of latter is higher, the investor will pay a premium that will reduce the total return on the trade compared to the spot price. Over time the difference may be significant (see Chart 2).

This matters for financial investors who are not interested in receiving the physical delivery of the oil they invested in and would have to roll their futures positions to keep the investment going. Consider the 2012-19 period. For most of that period, the market was in contango, measured by the difference between the prices of the first and fourth futures contracts. The total return of a long position on the first WTI oil futures contract, including the cost of rollover, was 25% lower than the spot price. Compared to a 38% drop in the oil price over the period, the total return for the investor was -63%.

Chart 2. WTI price, total return and contango, 2012-19

Source: ICE Futures Limited, Refinitiv and EFGAM calculations as at 22 April 2020.

Interestingly, the gap between the two yields - the beige line in Chart 2 - widens after strong contango phases in 2015 and 2016, which also came at the trough of oil bear markets. This highlights the risk of investing in oil in anticipation of a rebound after a sharp decline when the cost of rollover is higher. Rather, investing in maturities further out along the futures curve reduces the cost of rollover as the curve is flatter than on shorter maturities. In the case of an investment in futures contracts with a one-year maturity, the total return was higher than the spot price return in the 2012-19 period (see Chart 3).

Chart 3. WTI returns across the futures curve

Source: ICE Futures Limited, Refinitiv and EFGAM calculations as at 22 April 2020. Data rebased to 01.01.2012 = 100.

Another possible strategy is to invest in shares of energy companies. Historically, they have outperformed WTI spot price returns (see Chart 4). However, reflecting the downward trend of the oil price, have they clearly underperformed the broader US equity market.

Chart 4. WTI, energy sector and S&P500

Source: : S&P, Refinitiv and EFGAM calculations as at 22 April 2020. Data rebased to 01.01.2012 = 100.

In conclusion, it is hard to profit from an expected increase in oil prices after recent sharp falls. In the context of a high degree of uncertainty about the oil supply and demand outlook, the expectation is that the price will remain low. In this context, investing in shares of energy companies is the strategy that could offer the greatest possibility of return for the investor although not without meaningful risk.

 

 When spot prices are higher than futures contracts it is said that the market is backwardation.

Important source information: The sources for data used in this publication are EFG Research and Bloomberg, as at publication date, unless otherwise stated.

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Oil Investors macro flash notes.JPG