Whitney Tilson’s email to investors discussing his colleague Berna Barshay on the chaos in the oil markets.

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Q1 2020 hedge fund letters, conferences and more

The Chaos In The Oil Market

After more than 25 years since my first day on the trading floor, it's not often that I see something that I've never seen before – and never thought I'd see!

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But yesterday was one of those days, when the price for the May WTI crude oil future sank to zero... and then kept going lower. The contract – which closed at $18.27 on Friday – continued to crash throughout the trading session, shocking traders at each new level it hit. Surely it would stop at $10? At $5? At zero? But it in fact closed the session at negative $37.63... Yes, negative $37.63 per barrel. In other words, the seller of the contract would pay you $37.63 to take a barrel of oil off his hands during the month of May.

How is this possible? The answer lies in two stories of supply-demand imbalance...

The Supply-Demand Imbalance

First, there was the supply-demand imbalance for oil created by the global stay-at-home orders due to the COVID-19 pandemic. Suddenly, millions of people aren't driving to work, to their kid's soccer games, or to a weekend getaway. Flights were canceled as non-essential travel ground to a halt. And it wasn't just here in the U.S., but across all of Europe at the same time.

But wells that pump out oil don't work like your water faucet... It isn't so easy to just shut them off – and it can be even harder to restart them. As I wrote last week, oil production is set to be reduced by around 9 million barrels per day starting in June. But as producers prepare to take supply offline, the wells keep pumping out more oil... even as demand has dried up because of hundreds of millions of people sheltering in place.

Supply-demand imbalance No. 2 is storage. All that oil needs somewhere to go. It can sit at refineries, in pipelines, and on oil tankers at sea... but the receptacles that can hold oil are rapidly filling, thus causing the price of oil storage to skyrocket. The oversupply of oil combined with the dwindling supply of storage space led to the absolutely astounding and totally unprecedented negative prices that we saw for the May oil futures.

Difference In WTI Crude Futures Price

At the same time, the June WTI crude futures closed yesterday at $20.43. The difference between the May futures price and the June futures price implied that the market would pay you nearly $60 per barrel to store oil for a month – plus, you got the oil for free!

The trading relationship where the further-out month future trades at a premium to the close-in month (or spot price) is called "contango." It's common in the commodity markets, as the further-out months usually reflect storage costs and thus typically trade higher, except in times of short-term shortages (usually supply shocks).

But what happened yesterday could only be defined as "super contango," as it was something that we have never seen before and are unlikely to see again.

So why did this happen? Was there any news? Most likely the unprecedented negative oil futures price was the result of the May contract expiration today. Since commodity futures settle in the physical transfer of the underlying commodity (as opposed to a financial true-up), it seems a meaningful number of oil speculators got caught long the May WTI crude futures into their expiration, and didn't have the capacity to receive and store oil.

Compounding the issue of forced sales by May futures holders, the situation was probably exacerbated by speculation in the United States Oil Fund (USO) – the exchange-traded fund ("ETF") that tracks oil as a commodity. USO doesn't hold physical oil, but instead holds the futures. With the May futures set to expire today, that's one large holder who was forced to get out, thus driving the price down.

Who Benefits?

Now that we understand what happened, why it was so crazy, and the underlying factors behind such an historic dislocation, the next natural question to ask is: Who benefits?

Given the implied high price being paid for the ability to store oil for a month, the obvious beneficiaries of the greater oil supply-demand imbalance are the companies that can store it – the refineries, the pipelines, and the tanker companies. Thinking about the losers in this situation (besides the forced sellers of May WTI futures), top of mind has to be high-cost producers of oil, as they should be the first to be shut down in a demand-driven collapse in prices.

The high-cost producers in North American oil are the shale producers operating in the Green River Formation in the West and in the Devonian-Mississippian black shales of the East. These producers – who also tend to operate with high debt levels – should be the first to shut down.

But given the complexity of the fracking techniques used to remove oil from shale, these wells are extremely expensive to both turn on and turn off. If they are turned off, it's unlikely they will ever get turned on again, which could lead to the bankruptcy of many small shale producers.

Oil Sands At Risk

Also at risk are the oil sands of Western Canada, but with lower start-up/wind-down costs, it's conceivable that these fields are mothballed until a point when spot prices justify them being pulled back into service.

Even if May futures turn positive today before expiration, much damage has been done by the low absolute prices in the spot and near-term futures for oil, as well as by the soaring cost to store it.

The flip side of the distress at highly leveraged exploration and production (E&P) producers could be exciting merger and acquisition (M&A) opportunities for the better capitalized players in the space – which could include major global oil companies that still have the liquidity to do deals, even when suffering the fallout of lower oil prices themselves.

Other participants in this buyer's market for production assets could include private equity, or the Oracle of Omaha, Berkshire Hathaway's (BRK-B) Warren Buffett. Stay tuned!