Term structure: The bullish case for energy and crude oil

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• 0:05Speaker 00

  Hey everybody, it's Michael Martin. Thanks for being here. So, what in the world is going on with crude? And can we see $200 crude oil? Well, I'm not in the prediction market, but you know, when you see things close at the top right corner, it tends to want to keep going that way. So, the mistake you can make is think like, "Well, again, I could have had it down here. I was anchoring. I've missed the move." When you start to think about things like this, you know, where do you think it's going now? Right? Because now that you've got all this kind of space, it kind of frees you up, despite the fact that it is putting in new life of the contract highs. Right? So, what do we have?

• 0:48Speaker 00

  We have the ongoing saga between Russia, Ukraine, US and Iran, and now the third kind of playoffs here, where we have Houthis kind of attacking Saudi Arabia, which is all basically a thrust on the oil complex. Here we have, again, this is a moving average, and we're putting in, look at the volume there, putting in at the highs. Like, so let the, again, volume comes in after the fact, right? You can't really see that until the end of the day. But, you know, this is a lot of oil being traded at these new life of the contract highs. So, if you worried about being the only person on the baseball field,

• 1:32Speaker 00

  you can see that you're not. Right? Yeah, there was some below-average volume over here, but then Thursdays and Fridays business, as we were putting in, you know, those highs, this is the December contract. Okay, that volume doesn't lie to you, for example. Right? It's a monster volume, when you think about it. Now, if you look at USO, because futures might not be your appetite, it's the same kind of a deal. You can back this out and kind of see, you know, what's going on here. We have, right? About 7 million against an average of about 4, so well above the 125%

• 2:16Speaker 00

  of the average volume that you're looking at. This is the ETF, so you could trade options on this and not have a futures account, right? If you wanted to. As the ETF, it's fairly liquid, I guess. Millions and millions of shares. Now, let's take a look and see what's going on with the actual futures. With what we see here, so West Texas Intermediate, it's a light-sweet crude. That means that it's, when they say "sweet and sour", that has to deal with the sulfur content, which matters for refining, right? The more the sulfur content, the more expensive, like the Gulf of Oman and North Sea. Right? So, there you're talking about sulfur content.

• 3:00Speaker 00

  With all the emission standards and the green movement in the US, right? We have to refine out that sulfur. We cut the, what would they call it? Acid rain sulfur dioxide back in the day. And so, that just makes it more expensive. The light-sweet crude, West Texas Intermediate, has lower sulfur content in parts per million. So, that means when it's combusted, it's, well, it's easier to refine. It still creates pollution. Let's not fool around here. Now, you see other distillates that come from, you have ultra-low sulfur diesel and the reformulated blend stock for oxygenated blending, gasoline, basically no lead gas. All these markets are inverted,

• 3:43Speaker 00

  which means that the demand and the supply side is under shock. Right? So, the closest month is the highest price. And then, when you look at successive months, that are, you know, the deferred months, the prices go lower. For the ultra-low sulfur diesel, it's the same type of a deal. And for gasoline, even though we're not in driving season, there's a gigantic difference between 323.5 versus 303. So, it's a full 20 cents per gallon difference going out till February. And again, we're not exactly in staycation, you know, summer driving season. And so, what ends up happening, from a hedging standpoint

• 4:28Speaker 00

  and from a production standpoint, what you see here is a market that's under duress. Right? And a market that says, "We're tight on supply." Right? Or, we have above what we had perceived as seasonal demand. Now, I don't think that's the case. I don't think there's seasonal demand. Right? I think this is a function of the three wars that are going on. So, what, from a hedger standpoint, what they're saying is, "If you have inventory of crude oil, it's saying, 'Bring it to the market as fast as you can, because we'll pay you more.'" Remember, the cash market, despite what politicians might say and people who want to blame speculators, you have to understand that this is an insurance market.

• 5:13Speaker 00

  This doesn't drive the market. This insures the market, any more than if you have a car. Picture any particular car that's out there. A Tesla, a Prius, a Range Rover. If you buy insurance on your car, it doesn't make the value of your car go higher. It just means that you'll be indemnified if something happens to the car according to the terms of the contract. Right? In this case, it's the price. So, the cash market moves first, and the futures market follows. Right? It's true that when big buyers and sellers, they can push around the futures markets, but that's not going to change the physical market. That's not going to put an end to the war. So, they, you know, let's not let the facts interfere with a good story kind of a deal. Always understand that it's the cash market,

• 5:58Speaker 00

  also known as the physical or the spot market. The cash market moves first, and then the futures markets follow. Of course, there has to be a correlation, otherwise it wouldn't make sense. There wouldn't be a hedge if these markets weren't correlated to the actual underlying. In other, looking at it another way, if you had physical crude and you didn't want to deliver to the market right now, right? And it's hard to get the spot, right? The spot price, if you get plots, right? It's a lot of money. It's 10,000, 15,000 a month. There's no retail person out there that really has that. It's only for professional trading desks. Maybe Bloomberg, but even then, you're looking at 2,000 a month with a 24-month contract to get the service.

• 6:42Speaker 00

  So, most people don't have access to what the spot prices are. And mind you, there's probably, I don't know, 200,000 spot prices around the world at any given moment, right? Because they're all negotiated based on the particulars of that region, the currency, how long does it take for delivery? Is it insured? You know, that whole thing. So, what's going on here is the market is saying, "If you have inventory that you don't want to deliver to us now and you want to wait until February, we're actually going to penalize you 6 bucks." You see how that works? So, the market's saying, "Bring us everything that you have in terms of the physical as soon as possible, and we'll pay you more for it." Right?

• 7:26Speaker 00

  And with the volumes that you're seeing, they're probably getting it and storing it themselves so that they have inventory in case the situation gets worse. But that's what it means even for the ultra-low sulfur diesel right here, the ULSD, that's what that means. Ultra-low sulfur diesel. This is about $4.90, and if you go out to February, it's about $4.50. So, that's, you know, 10% cheaper. Right? So, it matters. They're basically penalizing you for storage here. Now, an interesting thing is this, is that when you think about carry charges, like, look at natural gas. There's not going to be any widowmaker, right? The widowmaker was like, almost a one-time event,

• 8:10Speaker 00

  and for some reason, that nickname applies to March, April, when it was really one or two years where that actually mattered. Right? There's a glut of natural gas, and that's why you see 12, 13, 14 cent moves, which is ginormous. Here, we have carry charges, which basically say, "We have enough inventory right now. You can in fact store it and bring it to us later, and we'll pay you more." So, the term structure of these markets can tell you a lot about what's going on with the supply and demand. Why? Well, because there's no Abby Joseph Cohen, there's no Greenspan put, there's no Mary Meeker, if you remember the 90s, the tech analyst at Morgan Stanley.

• 8:54Speaker 00

  There's no Axe that can move these markets. There's Saudi Aramco, right? There's that kind of a deal, and members of OPEC. But at the end of the day, so what you could normally do with this type of a market is you could trade spreads. And interestingly enough, when the markets are normal, what we call "normal markets" or "markets in contango", which is the fancy word, you can see that the deferred months have higher prices. And the difference between the successive months are called "carry charges", and you can calculate what those are. Now, don't forget, natural gas here of November 26th, that's the futures price. That's not the actual price for natural gas. Right?

• 9:38Speaker 00

  So, think of it as like the S&P 500. It's just a benchmark. It isn't the actual price of the gas. It kind of says, "Here's the neighborhood of the price." But then, when you're like the John Arnold's of the world, right? Really great traders. They understand that this is a, this is, like I said, it's a benchmark. There's a lot more that goes into how much someone's actually going to pay for the gas depending on how far it has to travel in the pipeline or in the intra-country network into the destinations of where you get it. You see? And they're really good at understanding what those relationships are. When markets invert, like in the petroleum complex,

• 10:22Speaker 00

  there is no upper boundary. So, whereas natural gas, theoretically would trade to full carry, it never really gets there. It doesn't always trade to the theoretic full carry amount. When markets invert, like in the petroleum complex here with gasoline, meaning, because gasoline comes from refined crude. So does sulfur. Ultra-low sulfur diesel. So does heat and oil. So does bunker fuel for ships. Right? So does kerosene. So does jet fuel A. It all comes from crude oil. So, higher crude oil prices, you know that the products, as they're called, or the distillates are going to be higher too. Right?

• 11:03Speaker 00

  So what happens is when the markets invert, there is no upper boundary. So whereas this thing might trade to like eighty-five, ninety percent of full carry when the markets invert, there is no upper boundary as to how high November can trade over December or DCE over Jan, right, or DCE over Red DCE, DCE of twenty-seven. So when you think about it, look at these, what, what happens is you can buy the front month and sell it the third month as a spread and, and create a profitable situation and you're hedged, you'll be on both sides of the market. It doesn't mean you're going to be immune from losing money because you could technically lose on both legs of the spread. But for example, you could have bought the November crude long and sold December short.

• 11:48Speaker 00

  Now you would have lost two dollars and fifty-two cents on your short, but you would have made three forty-four on your long. And so what is the net difference? It's not quite a dollar. It's eight cents, it's ninety-two cents, basically net, net on the spread. Now, if the market does correct and sell off, you'll lose on your November, but you'll make some of that or, or buffer yourself on the December. In this case, the spread, right, it would have lost, you've lost three cents. And in this case, it would have traded, you can do the math in your head, right, about nine cents. So it's possible that you can do that and trade the spreads when the markets invert.

• 12:29Speaker 00

  Same thing with, you know, so, um, the diesel market and the gasoline market. So you, you can, you can trade them long, you can use options, you can trade the spreads. But looking at these markets being inverted like that, it definitely says that there's either, either, there's a new demand, which there may be in, in the case that the, the folks who refine it might want to put it in storage so that they have it in inventory, right? Rather than be under duress and have to buy it while there's basically three wars going on in countries that are heavily involved in the petroleum market. Well, four, right? There's Russia, Ukraine, us in Iran, and Saudi Arabia.

• 13:14Speaker 00

  I don't know what the Houthis exposure to the crude market is in Yemen. So say that there are five countries that are in, heavily in the petroleum market, right? The U.S. is a big producer of crude oil. So what this basically says is there's a shock to the system when they invert like this. So when you look at USO and/or you look at crude oil and you look at the term structure of where the crude market is and the effect on the products, the reason, there's a couple of things. One, the reason why this can go higher is because people don't think it can go any higher, right? And then two, when you look at what's going on with the, the term structure, you can see that there's quite a bit going on.

• 13:59Speaker 00

  Now eventually, this is going to be for November delivery, so December will come and be the front month and you can kind of see where the volume is, you know, happening here. So don't be surprised. And then for the folks that are trading the equities, you have to think, okay, well, what do I have, you know, what equities do I own, right? Because don't forget, here's March, here's when the, the war broke out with Iran. So we've had six, seven months now of very expensive crude oil. Most of these companies that I understand aren't hedging. They figure that higher energy costs, they can pass off to the end user. So as you're watching earnings reports, be careful of the companies that have, you know,

• 14:43Speaker 00

  like FedEx or UPS or Carnival Cruise, like think of the companies that didn't hedge and had exposure, you know, what's that going to do to earnings? Because think about it, this is eighty bucks. We're two X now in six or seven months. Energy is twice as expensive now. And if they weren't planning on hedging that, like, you know, Southwest was very, had a great hedger in the treasurer's office, I think he's since retired. When we had peak oil back in two thousand and eight and it traded up to whatever it was, one thirty-eight or whatever, they had locked in their energy costs at around fifty-one dollars a barrel.

• 15:25Speaker 00

  And they didn't have to pass those costs in airfare to the end users. So they didn't have to get into a fare war where other, if you're traveling at all these days, you know, ticket prices are higher. So be mindful of how the energy costs, also while we're talking, look at interest rates, right? Bonds have been selling off, interest rates have been going higher, inflation is there, borrowing costs, it might take, you know, twelve months or so to filter into the system, but all those things, higher energy costs, higher carry charges on borrowing money can weigh on a company's earnings. So be mindful of this when you're looking at, you know, your investments and you read the chart, just realize that there's kind of a carbon monoxide that could be going

• 16:06Speaker 00

  on inside the earnings report, especially if the company is known to not really be active in hedging their, their risk like this. All right? Thanks for being here. It's going to be a short week. I'm on the road, so I will catch up with you next Monday. If you're listening to the show here on the audio platform, you can go look for the video on YouTube for the, at this episode of the same name. See you next week.