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OPEC s cuts have not yet had the desired effects
IT SOUNDS like a scene from The Big Short , a film about financial
speculation. Light aircraft fly photographers close to America s oil-storage
facilities, using infra-red imaging and photographs to gauge the rise and fall
of levels of crude in 2,100 storage tanks, in an attempt to work out whether
oil futures are overvalued or not.
In fact, it is less mischievous than that. The intelligence-gatherers work for
a company, Genscape, that sells the information to traders everywhere, giving
them a few days jump before storage surveys are published by the government.
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These data are particularly useful at a time when near-record levels of oil
inventories in America are weighing on oil prices and frustrating attempts by
OPEC, the producers cartel, to prop up the market. The high level of
inventories is vital to an understanding of why crude prices suddenly plummeted
this month, according to the International Energy Agency (IEA), a forecaster.
West Texas Intermediate is back below $50 a barrel, its level before OPEC in
November agreed to cut output (see chart).
Three reasons explain why the tanks are so full. Firstly, OPEC s agreement with
non-members such as Russia to cut production from January 1st set off a flurry
of hedge-fund buying, pushing oil prices higher. American shale producers were
quick to take advantage of higher prices by pumping more oil. The number of
American oil rigs has risen to 617 from 386 a year ago, producing 400,000
barrels a day more than at the lows in September. Much of that has gone to
storage terminals like Cushing, Oklahoma.
Second, OPEC has been hoisted by its own petard. In the months before it
started cutting output, it sharply raised production and exports. After weeks
of trans-Atlantic travel, this oil is showing up in higher American imports,
put into storage when refineries were idled for maintenance.
The third factor is the shape of the curve of futures prices, which is closely
related to the level of inventories. When OPEC orchestrated the January cut, it
hoped to rebalance supply and demand by mid-year, and push the futures market
into backwardation , meaning prices in the long term were at a discount to
short-term prices. Backwardation reflects the market s willingness to buy oil
and use it rather than storing it. The strategy worked for a while.
But since the release of bearish American inventory data on March 8th, the
market slipped back into contango , the name for the discount at which
near-term prices trade to longer-term ones. Contango makes it more worthwhile
to buy oil and store it. Hillary Stevenson of Genscape notes that the storage
costs in tanks in Cushing are about 41 cents per barrel of oil per month,
compared with a one-month contango of about 65 cents.
Contango can be a self-fulfilling prophecy, because the more oil is stored, the
lower short-term prices go. So OPEC s challenge is to try and break the loop,
possibly by promising to extend its output cuts beyond June. But in that case,
the shale drillers are likely to add yet more wells. And so the merry-go-round
will continue.