Thursday, February 19, 2009

Oil with Nowhere to Go

I used to get a kick out of the conspiracy theories about how there were oil tankers parked offshore waiting for the price of oil to go up. People have been talking like that since at least the early 1970s. And for most of the time, there was no truth to the rumors. Really, it’s expensive to charter an oil tanker. So who is going to waste money just storing oil offshore for months?

Stranger Than Fiction — Oil With Nowhere to Go

Sometimes truth is stranger than fiction. According to recent reports in trade publications, there are at least 80 million barrels’ worth of oil just floating around in tankers on the world’s oceans. From the Louisiana Offshore Oil Platform (LOOP) to Scotland to the coasts of the Persian Gulf and Asia, there are loaded tankers idling at sea.

How much oil is 80 million barrels? That’s about one day’s worth of global oil consumption. But it’s more than that. There’s never a day when there is zero oil output. From day to day, the global production of crude oil is a consistent number. So a change of, say, 1 million barrels per day could dramatically alter oil pricing. Even a few hundred thousand barrels, one way or the other, can move markets. So selling off a floating inventory of 80 million barrels could alter world oil pricing for several months at least.

Storage Is Tight

I’ve discussed in previous articles how storage space for oil has become tight in the U.S. In fact, according to the U.S. Energy Information Administration, there are 339 million barrels of crude in commercial stocks, which is 16% more than at this time last year. The vast crude oil storage tanks at Cushing, Okla., are topped off. And operators are even storing oil in unused networks of pipelines.

Meanwhile there is a slump in demand for crude oil and refined products in the U.S. This is forcing many domestic drillers to pull back on oil exploration and development of existing reserves. One example is Chesapeake Energy (CPK: NYSE), which was funding much of its ambitious land acquisition and drilling with credit.

In the last four months, according to figures from Baker Hughes (BHI: NYSE) over 800 drilling rigs have shut down just in the U.S., or about a third of the total rigs that were operating in the U.S. during the peak drilling period as of last September. Consider that each drilling rig employs between 50-200 workers, as well as a long supply chain for all sorts of things from fuel to food to drilling mud and welding rods. My back-of-the-envelope calculation is that 800 rigs represent about 100,000 laidoff employees. It’s going to make things tough for other oil service providers like Halliburton (HAL: NYSE) and Superior Energy Services (SPN: NYSE). Still, over the long haul, I think that the oil field service providers will stage a strong comeback. They have to. At least, if the world will still wants to use oil.

What of the Future? Contango

What of the future for oil? Where is the price of oil headed? Let’s look at something that’s pretty interesting. In addition to dropping 70% since the record high price of $147 per barrel last July, the oil market has gone into something called “contango.” This is a condition in which the PRESENT price of crude is less than contract prices for FUTURE delivery of oil. So it motivates energy market players to stockpile.

Here’s how it works. Let’s say that someone purchased oil this week at $41 per barrel. But that same barrel could immediately be sold via a forward contract for September delivery at a price of almost $53 per barrel. That’s a gross profit of about $12 per barrel, before storage costs.

Now let’s say that you have to charter a large tanker to store the oil. That’ll set you back about $75,000 per day for a vessel that holds 2 million barrels. Do some math. $75,000 per day to store 2 million barrels? That’s 3.75 cents per day per barrel to store oil, or about $1 per month per barrel. In other words, you could store oil at sea for six months and still have a profit of about $6 per barrel. No wonder the tankers are parked offshore.

Contango and the “Flying Dutchman”

If you’re not in the business, should you rush out right now and buy oil and store it? Well, it’s probably too late for newcomers to get in on the great deals. Right now, the contango spreads are sufficient to keep the current batch of tankers at sea for quite some time. (Shades of the Flying Dutchman, never pulling into port.)

Meanwhile, the contango price gap is closing. This is because OPEC has finally gotten some discipline and most of the member nations really are exporting less oil. Iran, for example, has at least 20 tankers lined up offshore. So when the contango price gap narrows or closes, the profit in storing oil will disappear. That’s why I think we are enjoying relatively low oil prices for now, and why we will see prices drift upward as 2009 wears on.

Let me caution you, however, that oil pricing will exhibit a vicious cycle for the next several months and probably into the spring and summer. As oil prices rise, operators will release their stored crude into the market. This will drive the price of oil back down again. In the process, these oil price swings are playing havoc with the world energy industry. Prices are too unstable. There’s some long-term development ongoing, but not enough overall. It’s going to come back and bite us in about 18-24 months, at the latest. Recession or no, it’s going to come back and bite us.

How About Gold?

Aside from the energy angles, I’m wondering how much to focus on precious metals. That’s because the dollar is going to get burnt into toast over the next few years. So I’m very bullish on precious metals like gold and silver. In the medium- to-long run, the stimulus bill will not be good for the U.S. economy. (I’ll discuss it below.) Indeed, the “stimulus” will be bad for the overall economy. But it will likely benefit precious metals companies like Yukon silver miner Alexco Resources (AXU: AMEX) and Mexican gold miner Canplats Resources Corp. (CPQ: TSX-V).

Both companies have high-grade ore in the ground. And both companies have enough money in the bank to fund the current operational plans. (Alexco has an environmental remediation contract from the Canadian government to pay the basic bills.) Meanwhile, both companies are attractive to potential suitors, like large miners that want to pick up some great reserves. And the prices of gold and silver are generally rising. In my view, both companies are there to buy, hold and wait with. Be patient. These eggs will hatch.

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