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Home , Contango, Cost of carry, Forward price, Futures contract, Margin (finance), Option (finance)

The Trade: A Competition By Lewis Hart

Black Friday 2014: As crude oil began their precipitous descent from $100 per barrel (bbl.) to less than $50 per bbl., a specter of protracted gloom washed over oil producers across the globe.

8 Brown Brothers Harriman | MARKETS UPDATE Energy exploration and production (E&P) companies, which between today’s for crude oil delivery compared with the future had been generating returns of more than 30% at $100 per bbl. price, also known as the time spread or the . of crude oil, suddenly faced a murkier future. The pessimism afflicting the producer community was perhaps only surpassed Daily Global Production and Consumption by the optimism – or perhaps opportunism – that swept across 120 oil trading desks in places such as London, Houston, Geneva, and 110

l . 100 Singapore. Traders welcomed the sudden return of price b b

f o

after nearly eight years of historically low levels. s 90 n

i l o 80 M WTI and Spot Prices 70 WTI Brent $120 60 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 $110 1 9 9 9 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 $100 Reflects production and consumption of liquid fuels Production Consumption $90 (crude oil, lease condensates, plant liquids, other liquids, refinery processing gains, and alcohol)

l . $80 b Source: DOE, EIA, Bloomberg and BBH Analysis

D / b $70

U S $60

$50

$40 Term Structure of Crude Oil Prices $30

$20 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 As with rates, the “term structure” in commod-

Source: Bloomberg and BBH Analysis ity prices refers to the relationship between prices for a given commodity for different delivery dates. When the is in contango, the spot price of the commodity WTI Monthly Price Volatility is less than the future price. Conversely, when the mar- 30% ket is in backwardation, the spot price of the commodity 20% is greater than the futures price. The relationship among 10% prices at different points across the curve is generally a

0% function of expectations.

(10%)

(20%)

(30%) The glut of inventory caused the spot price of crude oil to decline 0 5 0 1 1 2 2 3 4 5 3 4 1 1 1 1 1 1 1 1 1 1 1 1 ------c c c c c n n n n n more rapidly than the , resulting in an increase in u u u u u Sep - J J J J J D e D e D e D e Sep - D e the time spread. Traders who had secured -term oil storage Source: DOE, EIA, Bloomberg and BBH Analysis capacity at low rates in advance of the crash through ownership of storage facilities or long-term leases with third-party operators Enter Contango were pleased to see the market dislocation. Similarly, storage If the price crash was unwelcome to the producer community, operators who had not leased all of their storage capacity could market participants down the supply chain were not complaining, suddenly consider raising the rent. particularly energy merchants, crude oil storage operators, and refineries. The arrival of price instability was particularly welcome by companies whose business models included exposure to one of the key profit drivers in the energy trading business: the difference

October 2015 9 U.S. Crude Oil Cushing merchant could profitably purchase and crude, the 70 price by selling a , and still earn a profit, much attention was given to the pure cost of term storage – particularly 60 floating storage held in offshore tankers – with less emphasis

50 placed on an even more important variable: the structure and l .

b cost of a merchant’s capital.

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s

n 40 i l o M As capital providers and advisors to a number of energy 30 merchants, BBH received many inquiries from clients on financing contango trades during this period of price volatility. In this article, 20 we zero in on how a company’s cost of capital is a critical and often overlooked variable in determining whether a firm can profit 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 from periods of contango. Inventory stocks are measured as weekly ending inventory levels in Cushing, Oklahoma, and exclude strategic reserves. Source: DOE, EIA, Bloomberg and BBH Analysis The Carry Trade: A Crude Primer After two years of fairly flat and backwardated forward curves – The following variables must be considered when evaluating when the difference between the spot price and the 12-month whether it makes economic sense for a merchant to futures contract rarely exceeded $5 per bbl. – the forward curve enter into a contango or and carry trade: suddenly flipped into a condition known as contango, where the price for delivery in the future exceeded the price for delivery today by an above-average . Similar to the curve The Carry Formula in interest rates, the term structure of the crude oil market – where the price for future delivery of crude oil is set – can at 1. The crude oil futures price as traded on the exchange times present opportunities to earn profit with minimal risk for LESS companies that have the storage capacity – whether leased or owned – and the capital resources to take advantage of it. 2. The “cash” or “spot” price of a barrel of oil, which is the price for delivery today

12-Month Time Spread 3. The cost of transporting the oil to its storage location $15 4. The cost of storing the oil near an exchange deliverable location $10

Contango market 5. The cost of insuring the oil

$5 6. The cost of financing the oil

$0 = The Carry Profit or Loss

($5)

Backwardated 12-month minus 1-month WTI spread market

($10) When the sum of variables 2 through 6, also known as the

($15) Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 carrying cost, is less than variable 1, a merchant can in theory earn Source: Bloomberg and BBH Analysis an with virtually no risk by purchasing crude oil inventory today, placing it into a storage tank or offshore vessel, and selling As the market shifted into a steeper carry structure, popular media a futures contract. To help mitigate geographic basis risk, the outlets and research outfits covered the new pricing dynamic in storage must be located near an exchange. As such, given the depth. But as market observers evaluated whether an energy excess inventory in the marketplace, storing the crude oil for

10 Brown Brothers Harriman | COMMODITY MARKETS UPDATE future delivery to a refinery looked like a particularly interesting How Much Does Your Capital Cost? for merchants with inventory and access to storage. Working If the universe of merchants that had secured fixed price What factors drive each of these variables? Variable 1 represents storage before the arrival of contango was limited, the number the price for future delivery at a specific location (Cushing, of companies within that universe that could take advantage of Oklahoma, in the case of the West Texas Intermediate futures the opportunity was limited even further. The key driver of this contract). Price formation occurs through trading activity on differentiation is rooted in a simple concept the futures marketplace and is beyond the merchant’s control. known as the weighted average cost of capital (WACC). Similarly, the second variable is set through trading activity in the . Variables 3 and 4 can vary slightly based on We have found that merchants often consider only their cost whether a merchant has secured contractual transportation of capital when evaluating whether it pays to allocate a scarce capacity (via rail, truck, or barge) and storage capacity in advance resource such as to a potentially low returning, at a predetermined rate. Moreover, the storage cost can differ albeit low risk, contango trade. Looking at the total carrying costs, among merchants based on whether the merchant owns or financing costs should be lower than storage costs. However, leases storage facilities, when the storage rate was locked in, financing costs are generally a function of size and if the storage was leased for a period of time, and for how long other variables. As such, this element – variable 6 in the the lease rate was locked in. Variable 5, though not a major driver prior formula – tends to differ most among merchants and should of the economics, will generally be a function of a merchant’s establish the marginal . scale in the marketplace. Given the low risk profile, contango deals can typically be Merchants without the benefit of pre-existing storage capacity funded with high ; indeed, the inventory price risk is secured before the arrival of contango would be out of luck. As hedged, the inventory insured, and the oil often stored in or the forward curve steepened after the crash, storage operators near an exchange deliverable location or very liquid market raised rates to meet increased demand to store excess inventory. such as Cushing or Midland, Texas, where it can be turned to Storage – like all – becomes dearer as demand for cash quickly. However, these trades are rarely 100% leveraged, tank space increases relative to the supply of tank space. As meaning a merchant must allocate some balance sheet equity such, unless they had contracted storage in advance at a fixed to the trade. Furthermore, the leverage typically affects a rate or owned storage tanks, merchants were by and large shut merchant’s balance sheet leverage – a ratio capped by most out of the carry trade. commodity finance – and thus carries an opportunity cost.

Looking at the total carrying costs, financing costs should be lower than storage costs. However, financing costs are generally a function of balance sheet size and other credit variables. As such, this element tends to differ most among merchants and should establish the marginal cost of carry.”

October 2015 11 A Tale of Two Contangos To put it all into perspective, let’s look at a hypothetical but realistic example. In September 2012, with the cash to 12-month time There may be temporary arbitrage spread at approximately negative $1.00 per bbl., midsize energy merchant Arb-A-Little Energy enters into a five-year take or pay opportunities in a contango storage contract1 with a well-known operator for 500,000 barrels of storage capacity in Midland. Arb-A-Little agrees to a monthly market, but so long as the most lease rate of 40 cents per bbl. This contract gives the merchant the option, but not the obligation, to store oil in the facility. creditworthy companies have access to liquidity, they will likely Now fast-forward to November 2014: the cash to 12-month spread widens to almost $10.00 per bbl., peaking at around keep the time spread relatively $9.90 per bbl. in early March 2015. Arb-A-Little’s head oil , Stephen Smith, enters the office of CFO Gary Guttchek and says: narrow. The conclusion may “Gary, the cash to 12 has widened substantially! We need to be unsurprising, but few have fill up the tanks in Midland. I think we could make a big profit; we need to act quickly. I can make almost $2.00 per bbl. doing recognized that the contango nothing – just need to get the crude there as quickly as possible. That’s almost $1 million in profit for what doesn’t seem like much trade is ultimately a cost of capital work or risk.” competition – one that will likely Gary, skeptical by nature, tells Stephen that he will perform some always be won by companies with analysis that afternoon and respond to the trading proposal within 24 hours. As he begins to do the analysis – looking at the variables the cheapest capital.” described in the earlier formula – certain variables are easy to quantify: the cash price in Midland, the company’s previously locked-in storage and costs, and the futures strip for WTI crude oil. unrelated trading opportunities, which may generate superior returns for the shareholders. But calculating the financing costs requires a bit more reflection. Arb-A-Little’s from a regional bears an effective Gary begins doing the math and concludes the company’s of 3%, and the bank requires that the company WACC is actually 8.6%, assuming a comprising maintain at least 20% equity relative to total at all times. 80% debt and 20% equity, a cost of debt of 3%, and a cost of While the company could scramble to obtain off-balance financing equity of 35% (representing the company’s average return on from an alternative source, typically in the form of a -term equity over the past three years), and assuming a 35% federal , the costs and complexity are high, and corporate rate. Gary even uses the capital pricing model time is of the essence. To fund the transaction and use the full to back into the cost of equity and calculate a number in the same storage capacity, Gary would have to draw down approximately range. Suddenly, the economics don’t look so compelling at the $30 million on his line of credit, tying up a significant chunk of current $10 per bbl. spread. In fact, now equipped with all of the liquidity and depriving Arb-A-Little of the ability to capitalize on necessary information, Gary calculates that the company would actually generate a net present on the trade of negative $1,959,764 using the 8.6% number as the discount rate. 1 Take or pay contract: A contract that requires the buyer to pay for a contractually determined minimum , even if delivery is not taken. Its function is to move the from the producer to the buyer.

12 Brown Brothers Harriman | COMMODITY MARKETS UPDATE In order to generate a positive net present value given these high volume/low margin business and has also generated returns assumptions, the spread would need to expand to around $14.50 on equity in the 35% range over the past few years. per bbl. Even in this simplified analysis, Gary has yet to factor in the potential location basis risk – that in which the trader could have Arb-A-Lot is in a different . With these carrying costs to move the oil to Cushing in order to realize the WTI price. The locked in, as shown in the nearby chart, the company can change in the Midland/Cushing location spread over the carrying generate a net profit of $3.40 per bbl. Assuming a 500,000 barrel period could further erode or enhance the profit on changes in this trade, Arb-A-Lot’s trade would generate a net present value of pricing relationship. Now confident in his position, Gary goes back approximately $890,539. And the major difference lies in Arb- to Stephen and delivers a clear “no” decision on the trade. A-Lot’s WACC of 2.4%, compared with Arb-A-Little’s of 8.6% (calculated using the same rate). Arb-A-Lot’s CFO Now let’s take Arb-A-Little’s much larger global competitor, Arb- gives its head trader the green light to execute the trade. A-Lot. Due to its scale, Arb-A-Lot was able to negotiate a slightly better storage rate of 35 cents per bbl. around the same time in While market participants evaluate the attractiveness of this 2012 and at a nearby location with direct access to a pipeline. On arbitrage opportunity, conditions begin to change as prices respond the financing side, the differences become even starker. Arb-A- to the behavior of companies like Arb-A-Lot. By purchasing crude Lot’s line of credit from a consortium of international banks carries oil in the spot market, Arb-A-Lot bids up the cash and puts some an of just 1%. What’s more, the company’s downward pressure on the futures price given hedging associated leverage covenants are far less restrictive, requiring the company with the trade. Not surprisingly, the companies with lower costs to maintain a minimum equity level of only 5% relative to total like Arb-A-Lot win the cost of capital competition and correct the assets. Given the capital structure, Arb-A-Lot focuses more on temporary market dislocation. The efficient market returns, where earning a “risk-free” profit is next to impossible.

There may be temporary arbitrage opportuni- Arb-A-Little Arb-A-Lot ties in a contango market, but so long as the most creditworthy companies have access to Cash price per bbl. $60.00 $60.00 liquidity, they will likely keep the time spread Lease rate, insurance and interest $8.40 $6.60 relatively narrow. The conclusion may be unsurprising, but few have recognized that the Carrying cost per bbl.1 $68.40 $66.60 contango trade is ultimately a cost of capital 12-month futures price per bbl. $70.00 $70.00 competition – one that will likely always be won by companies with the cheapest capital. Capital Structure Debt/Equity Mix Cost Debt/Equity Mix Cost

Debt 80% 3% 95% 1% Equity 20% 35% 5% 35% Corporate tax rate 35% 35% Net profit per bbl. $1.60 $3.40 Net profit margin 2.3% 5.1% WACC 8.6% 2.4% NPV per bbl. ($3.92) $1.78

NPV for 500,000 bbl. ($1,959,764) $890,539

For illustrative purposes only. 1 Assumes lease rate, insurance and interest are all paid upon purchase of the inventory and assumes no transportation cost because storage.

October 2015 13 Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2019. All rights reserved.

PB_03082_2019_09_06 Exp. 11/30/2021