How a wrinkle in the oil futures market has clogged America’s oil pump

The U.S. is still the largest producer of oil, but we're a long way from pumping what we were before the pandemic. Blame backwardation.

View this email online Backwardation by Paddy Hirsch Our usual newsletter writer is knee-deep in some sweet powder this week (that’s snowboarding, to the uninitiated), so our editor, Paddy Hirsch, has stepped into the breach. This week: a story about how an obscure feature of the oil futures market is putting a big dent in America’s ability to produce more oil and bring prices down at the pump.   High And Tight The oil market right now is what the experts like to call ‘tight’. They’re referring to the supply side of the supply-demand equation: the amount of oil being released onto the market is comparatively low, or tight. Demand for oil, on the other hand, is high, and as every reader of this newsletter knows, when supply struggles to meet demand, prices go up. Demand is high because the global economy has come roaring back at what we hope is the tail end of the pandemic: as factories restart and people start getting back on the roads and up in the air, oil and all of its byproducts have become essential again. And energy companies are increasingly chasing oil as well now, thanks to a global natural gas shortage that has pushed many of those companies to shift back to burning the black stuff.  Supply is comparatively low for just two basic reasons. The first is that the OPEC plus cartel has decided not to pump any more oil than required by its existing quotas. The second is that American oil companies, and the investors who fund them, have stopped investing in the ability to extract more oil; what they call ‘putting money in the ground’. Instead they’ve been exercising what Wall Street likes to call ‘capital discipline’, which means diverting money to shareholders in various ways, and being punished when they don’t. This was understandable in the midst of the pandemic, when oil prices went to zero and investors got bludgeoned, but with oil now brimming at a hundred bucks a barrel, you’d think these companies would be pumping like mad. And yet, they are not. To understand why, take a quick look at the oil futures market. I took a screenshot of the state of the market after the close on Monday, February 21, at which point the spot price for a barrel of West Texas Intermediate (WTI) crude oil was $93.95. The spot price is what you’d pay for a barrel of WTI if you bought it today. The screenshot (hat tip to Marketwatch.org) shows the price of a barrel of WTI, if you locked in that price today and had it delivered at some point in the future, like in April or May or November, or whenever. Hence the futures market.   Screenshot   Usually, when supply is short and demand is strong, and expected to stay that way, we expect prices to rise in the future. We’d expect to see that reflected in the futures market, too: with prices for barrels being delivered in the future priced higher than a barrel delivered today. Futures traders have a word for this condition of the market: contango. And with supply as tight as it is right now, and demand as strong as it is, and with the possibility of war in Ukraine that could crimp Russian supply, prices should be very much in contango right now, right? But they’re not. Instead they’re in the opposite of contango: what traders call backwardation.   Seems backwards There are a couple of reasons the market is in backwardation right now. In a recent interview with The Indicator, Helima Croft, the global head of commodity strategy and Middle East and North Africa research at RBC Capital Markets, said that some entrepreneurial companies that stocked up on oil when it was in the dumps are now beginning to sell those reserves into these market highs. And traders think there's more of that supply to come. Traders are also hoping that OPEC will wise up and adjust their quotas to pump more oil, and bring some of the heat out of the market. They have projected this reasoning forward and figured that if all that oil comes up for sale at once, it will create a glut, which would surely depress prices. Combine that with the unnerving possibility of another variant of the Covid 19 virus locking down the globe again, and it’s no surprise that they’re bearish about the market. Big deal, you may say. Traders are speculating. That’s just what they do. But it’s not just traders who watch the futures market. Oil companies watch the market closely, too, as do the investors who invest in them, to determine whether it’s worthwhile putting money in the ground.  Those companies here aren’t like Aramco in Saudi Arabia, whose rigs are sitting on an aquifer of crude and can just amp up production at the flick of a switch. To get more oil out of the ground here in the U.S., companies have to build new rigs, drill new wells and install new extraction gear using expensive techniques. If they make the decision to drill today, they may not see a drop of oil or a cent in profit for a year. And when they see a futures market in backwardation, with prices falling until the end of the year, they tend to get reluctant about making big capital investments that may not pay off. That’s bad news for the American consumer, but put yourself in the oil companies’ position: if you owned a rental property, and you thought the rental market was going to decline in future, would you renovate your property and put in granite countertops and underfloor heating? Or would you maybe wait for a while? That’s how they’re thinking.   Over a barrel Before the pandemic, America was pumping 13 million barrels a day (bpd). Today, we’re still more than million bpd off that number. You may say that’s a good thing: shouldn’t we be weaning ourselves off fossil fuels and transitioning to alternative and clean energy sources? Certainly that’s what the government and many investors want to do, but that goal is a long way off. In the meantime, Americans are suffering. The government wants to keep prices down, but it doesn’t have many options. President Biden tapped the strategic oil reserve for 50 million barrels in November, and the world barely noticed. And no wonder: the U.S. guzzles that amount of oil in less than three days. What America needs to be able to do, if it wants to move the oil needle, is pump more oil, every day, every week of every year. But it can’t, because it hasn't invested in its oil infrastructure.  It’s not just backwardation that’s to blame, of course. American oil companies have come under a lot of pressure not to drill over the last few years, thanks to increased regulation, public interest in the role oil companies have played in climate change and local pollution, internal drives to rebrand as energy firms, and investor interest in environmental, social and governance (ESG) issues. In the past, these companies wouldn’t have thought twice about sinking a bunch of new wells. Today even talking about drilling is a tough call. Still, money talks, and it seems that hundred-dollar oil could be enough of an enticement to bring American oil firms off the fence. RBC Capital Markets’ Helima Croft said she knows of several oil firms that are beginning to drill again. However, she said, that capacity probably won’t come on line until the last quarter, and even then it probably won’t be enough. The futures market may be in backwardation right now, she said, but if her firm’s predictions are correct, that won’t last for long. RBC Capital reckons global demand for oil will rise by 4.3 million barrels a day by the end of the year. That could be good news for U.S. oil companies, who will have a good reason to drill. It does not, however, bode well for Americans who are suffering so much pain at the pump. Not subscribed? Subscribe to this newsletter. Want to spread the love? Share the web-version of this newsletter on social media. Craving more content? Listen to our podcasts. Newsletter continues after sponsor message On Our Podcasts Putin's big bet: Sanction-proofing Russia — The U.S. is imposing economic sanctions on Russia to punish it for invading Ukraine. But Russia has spent years trying to make its economy immune to sanctions. So, will these new sanctions be enough? Listen here How bad is inflation? — Two stories about the effects of inflation on the economy. We meet a gig worker who's seen an increase in wages, but because of inflation, how much of that increase in earnings is an illusion? 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