08 Jun OPEC Moves Closer to the Dream of Backwardation
Over the weekend OPEC agreed to a one-month extension to production cuts totaling 9.7 million bbls/d. The one-month timeline is shorter than the market is used to from OPEC, where they normally set longer-term goals and meetings. While the COVID crisis naturally requires a quicker response time, it’s also been indicated that by targeting near-term prices with more precision they can achieve the best possible outcome: a backwardated oil curve. This curve structure would be all upside for OPEC, achieving both pricing and market share goals as described below, and poetically also helps them punish Mexico for not cooperating.
Helps Maintain Market Share
Significant contango, such as we saw in March, results in very high tanker rates. This is because firms will take the tankers off the market to store crude and lock in a profit, net of fees, to sell the crude in the future at a guaranteed higher price. VLCC rates in March jumped from around $40k/day to well over $100k/day by month-end. If you are an oil-exporting nation that relies on tankers you need to avoid rates at extreme levels; Saudi Arabia actually saw buyers cancel April cargoes because the economics net of shipping no longer worked. Avoiding contango, and the resulting spike in rates is a good formula for keeping OPEC market share with buyers that need to use tankers.
Provides Less Capital to North American Shale
Backwardation forces North American shale companies, which hedge a significant percentage of their future volumes, to do so at lower future prices than the immediate prices that OPEC countries would be getting for their crude under backwardation. Not hedging isn’t an option for many producers as owners target a certain percentage of hedged volumes and lenders specifically ask for it. Hedging at lower prices would provide less future funds flow to reinvest into production and less capital through borrowing. As producers complete their borrowing base redeterminations twice a year the banks sometimes require a certain level of hedge certainty on the future reserve value. A lower present value from hedging would result in less lending capacity, not to mention forcing producers to hedge at prices they may not view favorably.
Disincentives Long-Term Projects
It’s in OPEC’s best interest to have long term supply gaps that allow them to return significant spare capacity to the market. A forward curve that is lower than the spot helps reduce final investment decisions on global megaprojects as they remain delayed until long term economics improve. This allows OPEC to set up a supply gap for several years.
Throughout the recent OPEC+ cut discussions Mexico has remained the one holdout. Mexico was asked for a cut of 400k bbls/d and only promised 100k bbls/d, asking others to make up the difference. Mexico is also the country that runs the most robust annual hedging program as they hedge most of their oil revenues a year in advance. The exact instruments, timing, and scale are always kept hidden (you never want someone front running one of the world’s largest trades) but the Mexican President has commented that it should return over $6 billion this year. As OPEC aims to shift the curve to backwardation this structure will make hedging far less profitable for Mexico which may help incentivize future cooperation.
Pulls Financials Into The Market
A great way to have higher oil pricing across the curve is by incentivizing financials to purchase crude contracts and this is more likely when the curve is in backwardation. This is due to the positive roll yield that those investors experience under this curve structure.
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