On March 12, 1912, Tom Slick watched as crude oil gushed 40 feet into the air from a well he’d drilled near the small town of Cushing, Oklahoma. The wildcat prospector quickly capped the well and covered his tracks with soil in an attempt to keep his discovery secret, then reserved all the horses and buggies in town to hinder potential rivals. It didn’t work. Word got out and Slick’s find was the start of a massive oil boom that attracted thousands.
Production slumped in 1916, but Cushing’s importance to the industry lives on and today every big player in the American oil market has eyes on this town of 8,000 people, still the nation’s key oil storage area and its most important hub for pipelines connecting producers with refineries along the Gulf Coast.
Cushing’s problem is that it is running out of space to store all the oil that is creating the present glut of the stuff, which in turn is pushing the oil price back down after February’s shortlived recovery and creating room for profit, sometimes in unusual ways.
The latest figures from America’s Energy Information Administration show that crude inventories are at the highest level in at least 80 years. Storage facilities are roughly 70 per cent full, with Cushing expected to “hit tank tops”, or reach capacity, within weeks.
When that happens, the oil price, already 50 per cent down since last June, is likely to resume its downwards spiral, as producers will be able sell only to buyers lucky enough to have storage. The questions then are: how low can it go? And for how long?
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“We should max out at Cushing some time in April or May,” says Brian Busch, director of oil markets at Genscape, a data company that monitors capacity in the area. When that happens, crude will go into storage down in the Gulf, where extra capacity is being built.
While he believes that fears of a steep drop in the oil price are overblown, Mr Busch agrees with many analysts that the storage crisis will push crude prices well below $40. “I certainly think it’s possible for us to test levels of $32 if we don’t see excess supply slow down.”
Tom Kloza, of the Oil Price Information Service, agrees, saying the price could sink to $35 in the next 30 days or so.
Jan Stuart, a commodities analyst at Credit Suisse, believes that this downward pressure will increase the price differential between North American WTI (West Texas Intermediate) oil, currently trading at just under $50 per barrel, and Brent oil from the North Sea, trading slightly below $60. “I wouldn’t be surprised if, for a very short while, WTI prices slip into the $30 range,” he says.
Looking forward, many analysts see the oil storage crisis as a three-act play. In act one, where we find ourselves at the moment, tanks at Cushing get filled up. In act two, land-based storage elsewhere is also so backed up that every oil tanker is used as floating storage space. This, in turn, pushes down the Brent price because that oil can’t be moved then, either.
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In the third and final act, the oil stays in the ground. First, this hits the highest-cost producers in Brazil and Angola. Maybe Canadian oil sands producers cut back, too, and a few American shale drillers. Opec countries, with break-even prices of $5 to $20, would be the last to blink under this worst-case scenario.
Few analysts or traders believe that the world will reach act three; most expect a pick-up in demand and prices in the second half of this year as cheaper oil stimulates factories in Asia and Europe. Many also note that America’s refineries are in their maintenance season and once this is over, demand could pick up.
Mr Busch adds that “driving season” in the United States, between the Memorial Day public holiday in May and the Labor Day weekend in September, will start soon. Once it is, families will head to theme parks, mountains and beaches by car and demand for oil can be expected to increase by as much as a million barrels a day. To put it in context, US producers have been bringing out of the ground an average of seven million barrels per day of excess supply over the past three months, despite the closure of many wells.
However, the storage crisis is not a result of mere overproduction. It is being fuelled by a curious phenomenon known as contango, which occurs when futures prices are higher than the front-end price because traders and investors believe that demand and prices are set to pick up at some point. This creates an incentive to buy oil now, say at $50, with the hope of selling it in three months, maybe at $53.50. If storage costs come to just 50 cents per month per barrel and borrowing costs remain negligible, the potential for profit is clear to see.
Contango itself is not new. What makes a big difference this time is that it coincides with very low interest rates. This provides the potential for a nice return on borrowed capital and is also very secure if you believe, as many traders clearly do, that demand will pick up.
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As Mr Kloza says: “Right now, if you have access to cheap borrowing and storage tanks, oil is as conservative an investment as a savings passbook.” Now that’s a situation that Tom Slick, the King of Wildcatters, would have been very happy with.