SPR sales continuing

February 13, 2023 PR from the DOE:

WASHINGTON, D.C.— Today, the U.S. Department of Energy’s (DOE) Office of Petroleum Reserves announced a Notice of Sale to meet its obligation to Congress to sell 26 million barrels of crude oil from the Strategic Petroleum Reserve (SPR) in Fiscal Year 2023. This sale will fulfill the congressional mandate set forth in section 403 of the Bipartisan Budget Act of 2015 and section 32204 of the Fixing America’s Surface Transportation Act. The deliveries will take place from April 1 through June 30.

In accordance with the laws, DOE will release up to 26 million barrels of sweet crude oil from two SPR storage sites, with deliveries beginning as early as April 1, 2023. DOE must receive bids for this notice no later than 10:00 a.m. Central Time on February 28, 2023. Contracts will be awarded to successful offerors no later than March 8, 2023.

We see these sales have started at the beginning of the month:

From 03/31 to 04/14, there has been 3.212 million barrels sold, or about 230,000 barrels per day.

If this pace continues, the 26 million barrels will be sold by the end of July.

Oil futures curve finally flipped

The following is an extract of the WTI oil futures curve:

The price of current-day (spot) crude is about 1% cheaper than the price of oil half a year out.

Let’s run a refresher course on the basic mechanics of futures pricing.

All things being equal, a clean futures curve will price the interest rate curve into forward prices, minus storage costs.

For instance, if today you can buy a barrel of oil for $100 and tomorrow you can sell it for $110, you would want to dig the trench in your backyard and store the oil there for a day so you can sell it for 10% profit. (You can do the math on an annualized return over a day!).

Ignoring storage costs, if you have to chew up $100 of capital to hold your oil, there is an implied carrying cost to holding that oil instead of selling it immediately to put into risk-free securities. This is a function of interest rates.

So a theoretical market would reflect this opportunity cost loss.

Let’s pretend your interest rate is 5%.

One would be indifferent to a $100 spot price today vs. $105 a year from now, again, emphasizing no storage costs.

For financial futures, other than a few electrons, there are no storage costs. This is why you see S&P 500 futures pricing up roughly a percent for each three months of the contract duration. Sophisticated funds can arbitrage by buying the index today and selling the future 3 months out, and pocket the spread – don’t forget about those equity dividends! This is a very roundabout way of investing in a 3 month interest product.

However, for commodities, there are storage costs and also the ebb of projected supply and demand characteristics of the underlying. An example from the natural gas market – the blowup at the Freeport LNG facility (which is still under repair) had their futures project, quite rapidly, increased supply over a limited time frame. When the promises of an early repair date evaporated quicker than LNG at room temperature, the futures curve adapted accordingly.

Another variable concerning physical commodities is that physical ownership might convey some other benefits that come with income – such as gold leasing.

Going back to crude futures, this is the first time awhile where the spot month is exhibiting a “normal” sloped curve, at least for the first half year or so. The “peak” of the curve is in October 2023 and then the price slopes downward again. This is an unusual situation.

It’s been clear to me since the June peak that the game has changed from one of scarcity to one of much more conventional metrics – can you identify the firms that will survive in a lower price environment? Do you actually want to be in a space that might potentially be a “grind to the bottom” again as companies increase capital investing and have balance sheets to sustain potentially unprofitable production?

We went through that in 2014, where supply really accelerated and crushed the crap out of the oil and natural gas market.

The question here is whether supply is nearly as constrained (either for ESG reasons or geological reasons) as the narrative would suggest.

Lumber and cyclical markets

You could mistake the chart above for a technology company’s stock, but indeed it is the spot price of lumber per thousand board feet (about 2.4 cubic meters).

From a peak of $1,700 to $400 today represents a 76% drop.

What happened after Covid is now well known – demand for lumber went through the roof as people decided to focus on home improvement, while supply was curtailed due to labour issues.

As a result, 2020 to 2022 were record years for most lumber producers. We will use an example of Western Forest Products (TSX: WEF):

For the 12 months between Q4-2020 to Q3-2021 they made 56 cents per share.

Given that their stock was trading at around $2/share at the end of that period, you were looking at a price-to-earnings of 4, and even less on a price-to-free cash flow basis.

Four times past earnings looks like a very cheap valuation metric. However, had you invested in the stock at the end of Q3-2021 ($2.20/share), today you would be sitting on a loss of nearly 50%.

News is still not very good. Increasing interest rates, a moderation in the supply chain, and also the fact that nobody wants to work on their outdoor deck three years in a row has contributed to prices going back to ambient pre-Covid averages.

A few days ago, Western Forest announced:

Western Forest Products Inc. (TSX: WEF) (“Western” or the “Company”) today announced plans to temporarily reduce its lumber production output for the remainder of 2022 by approximately 20 million board feet to manage inventory levels to current market conditions.

Basically they’re taking most of December off. Hopefully the workers will have a good Christmas, but 2023 will bring more uncertainty. Uncertainty results in decreased prices.

Five analysts have put the 2023 fiscal year at an averaged estimated EPS of $0.22/share. At today’s stock price of $1.13, that would still be at a P/E of 5.

Despite the P/E expansion (going from 4 to 5 is a 25% increase), an investor at the cyclical top has lost a considerable amount of capital.

I also suspect that the 2023 estimate is still high.

It’s really difficult to sell something when you see the P/E at 4, but it was the right choice. My final sale was in May of 2021 at $2.25/share.

Investors in other commodities should be given caution. The tempo of commodity equities varies with the commodity, but universal to them all is the cyclicality. Time it well.

The Biden Oil Put

Link to: FACT SHEET: President Biden to Announce New Actions to Strengthen U.S. Energy Security, Encourage Production, and Bring Down Costs

Quote:

DOE has finalized a first-of-its-kind rule that enables it to enter into fixed-price contracts with suppliers, through a competitive bid process, to repurchase oil for future delivery windows. This new authority will shore up demand for oil when supply is less uncertain and prices are anticipated to be lower. For example, if the market were to price barrels for delivery in mid-2024 at $70, the new rule allows DOE to enter into a contract now for mid-2024 delivery of oil at, around or lower than that price. DOE plans to use this authority to enter into contracts to repurchase oil for the SPR, targeting a price of about $67 to $72 per barrel or lower, with initial repurchases being delivered in 2024 or 2025. In addition, DOE is prepared to undertake additional SPR repurchases at times when the price of oil for current delivery drops to about $67 to $72 per barrel or lower, supplementing its future fixed-price contracts as appropriate.

SPR Reserves – September 30: 416,319 million barrels remaining – October and November will feature another 25 million barrels or so out of the reserve.

Notably with the above quotation, it puts an effective floor on oil pricing for a certain amount of capacity. This has the makings of a one-way trade, providing that demand does not collapse to the point where prices go even lower than that due to perhaps an impending recession in 2023.

Always interesting times ahead, navigate carefully!

Completely insane – May 2020 Crude Futures

The May 2020 futures contract expires on April 21st, but nobody wants the oil!

Attached is a chart of trading today in May 2020 crude futures. Amusingly enough, Interactive Brokers doesn’t support negative price quotes, so I couldn’t chart it through TWS:

I have never seen anything like this before in my life – you buy a contract for 1,000 barrels for negative $40. The counterparty pays me $40,000 and I take delivery of 1,000 barrels of crude oil. I then go light it on fire.

What a strange, strange world we live in.