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There’s a glut of oil storage capacity at the Cushing, Okla., trading hub where West Texas Intermediate crude is priced.
Johannes Eisele/AFP/Getty Images
The price of oil is closing in on $100 a barrel, but that’s not the great windfall for crude producers it seems like it should be. The oil futures curve is in a particularly steep “backwardation”—that is, near-term front-month prices are meaningfully higher than future prices.
Oil stocks haven’t done badly, mind you. The
Energy Select Sector SPDR
exchange-traded fund (ticker: XLE) has gained 17% since late June, far more than any other sector over that period.
he front-month price of oil, however, has surged nearly 40% from the high $60s per barrel to a recent $93. The problem is that the November contract—the current front month—for West Texas Intermediate crude oil expires on Oct. 20, while the December contract has oil at $90.50 and January’s puts it at $88.50. It’s a greater drop-off in oil futures prices over the coming months than usual.
The steeper-than-normal premium for spot oil over futures is due to several supply-and-demand factors in the market. Saudi Arabia and its oil cartel allies are holding down production to boost prices. And there’s a glut of oil storage capacity at the Cushing, Okla., trading hub where WTI crude is priced.
“In the three decades that we’ve looked at this sector, any time Saudi is not challenged for market share it will defend price,” writes Doug Leggate, U.S. oil and gas analyst at BofA Securities. “But the consequence of artificial price support is that backwardation is embedded as a permanent characteristic of the futures curve. So, while oil above $90 is clearly positive for near-term sector free cash flow, longer-dated prices depressed by a spare capacity overhang remains a tangible headwind to valuations.”
BofA commodities strategists have a long-term price estimate of $80 a barrel for Brent crude, the international benchmark, which was recently trading for around $96 a barrel. WTI should follow a similar pattern—strategists and futures markets agree that oil prices won’t always be as high as they are now.
Higher prices today than those expected in the future means that energy stocks aren’t getting full credit for the rise in spot, or current, oil prices. It advantages those producers with the ability to drill or frack the most oil today, and those with the most productive near-term uses for their cash flow. Leggate likes
Occidental Petroleum
(OXY), in particular.
Occidental has been directing excess cash flow to pay down the $10 billion in 8% preferred stock it issued to Warren Buffett’s
Berkshire Hathaway
(BRK.A) in 2019 to finance the purchase of Anadarko Petroleum. That’s an expensive source of financing—using today’s cash windfall to reduce it will benefit Occidental for years to come. At the same time, Berkshire has been buying up common shares of Occidental, and now owns 25% of the company.
“Of our oil-weighted coverage we see OXY best positioned to capitalize on near-term oil strength while capital efficiency, a deep drilling backlog,[and the Berkshire] ‘put’ can help mitigate downside risk if some of the caveats laid out by our commodity team are borne out,” Leggate writes.
That’s one way to handle the curve.
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com
