Oil markets turned upside down as the May WTI futures contract slipped into negative territory earlier this week. The move was driven primarily by concerns about the shortfall in available storage capacity at Cushing, Oklahoma, the pricing point for Nymex crude oil, exacerbated by a liquidity crunch due to reduced lending support from the financial system, as one of the largest private oil trading houses in Singapore revealed it failed to declare $800 million in losses. 

 

The June contract has also come under pressure, declining more than 35% on April 21, as market participants continue to signal that production shut-ins from existing wells are required to prevent tank tops at Cushing next month, says a Barclays Commodities Research report.

 

The key reason why storage capacity at Cushing is on the verge of being overwhelmed (about 75% full at the end of last week, by our estimates) is the inherent lag in the supply response to a fall off the cliff in demand. Implied gasoline demand in the US has fallen about 45% y/y, according to the recent weekly estimates from the DOE, as the general public in most of the states in the US is under stay-at-home orders, while reduced drilling has not yet had a material effect on oil production. 

 

Even if gasoline demand in the US recovers slightly next month on some easing of virus containment measures if the spread continues to slow, it will still be down significantly y/y, due to lackluster economic activity. Hence, 1-2 mb/d of production shut-ins will likely be required to prevent tank tops at key storage hubs in the US, by our estimates, which is what benchmark prices are signaling, says the report.

 

Shutting in production from existing wells is difficult, given the cost implications from existing leasehold and midstream contracts, in addition to a potential deterioration in well performance. But something's gotta give and sustained low prices might not leave producers with any other viable option, especially smaller, private operators that control almost 40% of the combined Texas, North Dakota and New Mexico production, according to data from Evenrus, and have relatively limited flexibility in marketing ability. 

 

Smaller scale and less efficient operations mean these producers generally have cash costs of production in excess of the average $10-12 per barrel for L48 onshore output; spot prices in the Permian and Bakken regions are already below that level. Some of the large, listed operators, such as Continental Resources and ConocoPhillips have also announced production shut-ins recently, Barclays report says.

 

With a gradual recovery in demand and a lagged but material supply response, a reversal in the surplus at Cushing is inevitable, but the timing is key and it remains uncertain. Options prices are implying a 40-50% chance of the June WTI contract falling to zero, but the structure of the front end of the futures curve is signaling a peak in storage concerns in April. 

 

"The shape of the oil futures curve is influenced by many factors, including physical demand-supply conditions, hedging by producers and consumers, and a risk premium/discount for potential supply disruptions or storage shortfalls, in addition to changes in speculative positioning. However, the front end of the curve is the most influenced by the prevailing physical demand-supply situation, in our view, and its current structure indicates that storage concerns will peak this month," the report says.

 

"Despite markets pricing in a significant probability of the June WTI contract also falling to zero, we think the situation will likely be averted; given the current virus trends, demand in the US will likely trough in April, a significant amount of oil production will likely be forced to shut in due to depressed prices and the lagged capex-induced production reductions will likely also start showing up next month, albeit in small numbers, bolstered by a reduction in Opec+ supplies as part of the recent agreement," the report says. - TradeArabia News Service