The Game of Oil

I've been watching oil news like a hawk because this is something that is screams "opportunity." Whatever you do, don't simply buy oil because it looks cheap, what you really need to do is understand the story, wait until the right signs come together before taking position.

Oil Prices will continue to decline

So long a supply runs higher than demand, oil prices will continue to fall. The biggest impacts of falling oil prices is reductions in revenue for all oil producers. Not all wells are the same. Country and region, each drilling site will have a different cost for every bbl of oil extracted. Every company will also be in different financial positions to handle the current falling prices.


Doing some cursory research, there are many oil and gas companies in the US with varying levels of debt and cash on hand. In addition to this many of them have hedged their future deliveries throughout the year. I am willing to venture that most of these companies will be able to continue running for the next several months until their hedged positions expire and then these companies will need to plan their next move.

Let's take a look at the recent futures curve for oil for WTI:

We see in this case for the Feb delivery hovering near $50, the market is pricing  expect that oil prices will recover to around $55 by next year and hit $70 3~4  years out. Supposing that you took delivery of 1 barrel of oil now, bought the future to deliver the oil a year later, you'd be looking to make 10% on your investment (excluding storage costs). Adding in costs for the storage and transportation perhaps this profit would be a little lower at about 8%. Comparing this against the current 1 year US treasury rate of 0.25%, this is a no brainer manoeuvre.

What we'll be seeing is that oil storage companies will be turning a sizeable profit by simply buying excess capacity and storing them for the time being to sell the oil later on at a profit.

A typical play during these times would be to use takers as floating storage facilities for the oil. A typical supermax 200k barrels of oil and would run approximately $9k/day in costs. Calculation in this case would yield a net loss, so don't start banking on seeing shipping companies coming into play just yet.

The downward trend will continue until there is blood

One thing I am fairly certain of at this time is that there will be no change change in this trend until there is a change in supply. Growing demand will lag after plentiful supply and even if this current current situation lasts for 1~2 years, I highly doubt that demand will pick up fast enough to take in the additional oil supply just yet.

What we know right now is that all new exploratory projects and new drilling activities are being stopped for the time being to allow all companies to extend their financial runway. The game at this point is to be the last company standing as less capitalized companies start to go belly up, this is when we'll finally start seeing reductions in oil supply. 

Currently all the news headlines are currently pointing toward reductions in exploratory services and new drilling. Excess staff that isn't required to simply pump oil out of current running wells will likely be jettisoned to give the current companies as much runway as possible to keep going to survive.

Of course, larger geopolitical events could also cause large movements in the market. One as such is the default of Russia. A cursory look into this from an article from Bloomberg indicating that their reserves have shrunk by 20% in just the last year. The burn rate could increase with increasing devaluation of the rouble, but even in this case, I would assume that they have enough funds for the next 2~3 years before going to default. Though this will not likely spell collapse of Russia, they will have had a critical blow dealt to them, though not enough to cause collapse and chaos (some conspiracy circles would say that the US and Saudi Arabia are working together to make this happen to keep Russian influence minimal in the Mediterranean after the take over of Chimera). 

How could this situation be played?

There are 2 ways that I can see with this current oil situation.

1. Look for the bottom:

As the saying goes, down catch as knife as it's falling. In this case, let it hit bottom when you have seen the right signs of it hitting the bottom. Meaning that we see production decrease with steady demand. In sure time, we'll see an increase in price. Most likely there will be some companies that have gone bankrupt. The companies that are still left standing will be in a great position to capture market share and take advantage of increasing prices. I'd say invest in them for the long term. You could also buy oil ETF to track the price of oil as it  goes up.

2. Go for the futures spread trade

Maybe we won't know where the long term price of oil will be. There are people now talking about the "new normal" of oil prices being around $60-$70 in the future. Perhaps that prices will be lower. Once thing that we can be certain of is that the oil market will stabilize and the spread between the prices now and later will shrink as what it looks like in the following graph:

What you could do in this case to anticipate the shrinking of the spread between now and the futures say a year later would be to buy the most current futures contract and sell the a contract 10 months to a year out and wait for convergence of the yield curve.

Futures 10 months out from now will have slightly poor bid-ask spreads but assuming that you are not trading these heavily, you could simply just hold these while rolling the most recent contracts to capitalize on the shrinking calendar spread.

At the time of this writing, the Feb 2015 contracts are trading for 49.20 and the Dec 2015 contracts are trading at 56.38. Assuming that the market will eventually stabilize, either the Dec futures will bet cheaper or the more recent futures will increase in price (or a combination of the 2).

The delta here is about $6k per contract and taking in to account additional slippage, taking the March 2015 forward contract there is a $0.5 gap between the bid of the Feb contract vs the ask of the March contract. Let's take the assumption that the curve does flatten such that the gap between the month to month spread shrinks linearly to $0.25 after 10 months. You'll lose in total of $3.375 in monthly spread costs you might be able to get away with $2.6k in profits.

Given different scenarios for spreads after 10 months:

• $0.5 monthly spread down to $0.25 gives $2.625k in profits
• $0.5 monthly spread down to $0.15 gives $3.05k in profits

Good luck.