Contango & Cash

This article was originally published on on March 24th at 5:00pm EDT

I think most of us have heard enough about oil in the last six months for a lifetime. Whether we like it or not, oil is a pretty important topic, and its price and volatility impact just about every other asset class. There seems to be some confusion about what’s actually going on, and the role OPEC may or may not be playing.

“OPEC is broken. The cartel, led by Saudi Arabia, is no longer able to control the price of oil.”

Really? How are they not controlling the price of oil? Saudi Arabia is, by far, OPEC’s largest producer and has committed to keeping the market oversupplied in an effort to bring down the price and, hopefully, knock some people out of the game to regain market share.

Seems to me they are quite firmly in control of things. The price of oil is exactly where they want it, and they will cut production—whether it’s a coordinated cut or not—when they are good and ready.

“Saudi Arabia can let oil prices stay this low forever. We had better get used to it.”

The above statement—and we are hearing things like this every day—could not have possibly come from someone who is good at math. Can Saudi Arabia survive with oil prices at $50? Sure. But they don’t have to. And they don’t really want to.

Let’s be conservative and estimate that the global benchmark Brent Crude is $50/barrel lower today than it was a year ago. Let’s also assume that Saudi Arabia exports 10 million barrels a day. That price difference means Saudi Arabia is taking in $500 million less every single day with oil at these current levels. That’s $15 billion a month. If prices stay where they are that’ll be $180 billion year-over-year differential. Whether they can handle it or not isn’t really the question, but how long will they have to handle it until they get what they want out of this exercise.

“Saudi Arabia wants to destroy U.S. shale production.”

That could be. I just don’t think they’ll be able to do it. We know that U.S. production is up about 50% in the past four years since the efficiencies of domestic shale became both known and functional. The result is we need less of Saudi Arabia’s oil. There are plenty of other buyers for their oil out there, though.

Because we are now producing more oil than we need in the United States, and can’t legally send it anywhere other than storage tanks and refineries, the price of WTI is substantially lower ($8-10 per barrel) than that of Brent. But something now being discussed, albeit informally—repealing the ban on U.S. exports—would be the nail in that coffin, and would deal a major blow to OPEC.

I hear market commentators talking about these low energy prices with some sort of permanence, and as a “gift” of sorts. I think this is a little shortsighted. After all, a gift is something one gets to keep.


The only parties for whom these low energy prices will have any staying power—and therefore real benefit—are those with the capital to lock them in for a long period of time, either by storing it in tanks or via financial instruments (futures/options) which require large capital outlays today. In the futures market, a buyer can come in and commit to buying a large quantity at today’s reduced prices and push its “delivery” out for months or even years. Prices in the futures market out one year are about $10 per barrel higher for both domestic West Texas Intermediate (WTI) and Global Benchmark Brent Crude, still well below the average price over the past five or even ten years.

Another way to capitalize on this phenomenon, known as ‘contango,’ is to buy a boatload (literally) of oil at today’s prices and sell it immediately—via futures contracts—out a year to someone who will accept delivery at that time. Of course this only makes sense if today’s prices are lower than prices further down the curve. As this differential widens, suggesting higher prices in the future, demand for oil today picks up. We are seeing that now.

…& Cash

Notwithstanding the y-o-y declines we mentioned above, Saudi Arabia needs oil at about $100 per barrel to balance their budget (and not continue depleting their $700 billion USD reserves). They have no interest in lower oil prices for the long term. Consider the algebra problem where A x B = C and ‘A’ is the number of barrels of oil they export, ‘B’ is the number of dollars each barrel commands, and ‘C,’ obviously, is Saudi Arabia’s revenue from oil exports. A higher market share (A) is only a net positive if the price (B) stays constant or pretty close to it. In other words, maintaining their market share (about 12% of global production going back 15 years) is not a victory if the price (B) drops by more than enough to offset it.

Consider that Saudi Arabia would need to double their exports (from 9 to 18 million barrels per day) to achieve the samerevenue (C) as they did on an annualized basis a year ago. But they are nearing maximum capacity at close to 10 million barrels per day right now…

What does Saudi Arabia really want?

This one is pretty simple. Saudi Arabia wants oil prices as high as possible without: 1) Curbing demand, or 2) Allowing every producer on Earth to operate at a profit (and thus impinging on their own market share). As far as demand is concerned, keep in mind that there was no issue with demand from 2011 to 2014 when oil was over $100 per barrel. And how much does Saudi Arabia actually lose with each percentage of market share they forfeit to other producers? That depends a great deal on the price of a barrel.

So before we jump to conclusions about what Saudi Arabia’s goals are, and at what price oil’s final destination may be, let’s think about what Saudi Arabia would need to happen in order to maximize their profits.And that is higher, not lower, oil prices.

Look for a coordinated production cut from some of the major producers whose governments control oil exports in the next few months. Cuts in the U.S. come differently as our production is independent and controlled by the capital markets rather than government. And while rig cuts here have yet to slow production meaningfully (if at all), it is just a matter of time before domestic production maxes out and reverses course a bit.

This does not mean that our energy renaissance is over—as with any bull market, there are corrections along the way.

If you have questions or would like to engage in a dialogue, please don’t hesitate to give us a call.

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.

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