Curve Control

This is it, we lost the war. Oil finally won this week, and I am not talking about today’s or yesterday’s price, those are just battles, this is the war:

Exactly one month ago, a barrel of Brent was worth exactly the same as today, $94, however, what changed is the part further out, look at Dec27, it is already close to $80, which does not mean that oil is going to be worth $80 by the end of next year, the futures curve is rarely a good predictor of prices, but it can predict something:

If I am an oil producer, I have the possibility of selling all my production for next year at ~$80, today, with a phone call to my broker.

And it is happening. The oil news cycle now alternates between Hormuz and exploration agreements, block concessions, Namibia, Angola, Petrobras, Continental, Permian...whatever… these cats are active.

$80 works for the industry. There is something you need to understand about oilmen, they are not happy making money, they are the most happy drilling holes in the ground, and $80 guarantees another good year doing what they love, and now they have their own money to do it.

Assuming $75 WTI or $80 Brent, any E&P has a guaranteed ROA of ~7 to 10%, that is, if they can get the rigs, which could become a problem between now and year-end. But the decisions to drill are being made, two months ago they were not, that changed.

The expansion will once again come from the Americas, where production has been growing lately, but not because of the price signal, rather because of efficiency gains. All these projects that are just now producing their first barrels were planned with oil at $65. At $80, projects already underway accelerate, and we could potentially see more because these prices guarantee financing, that was too busy pouring money into datacenters, this looks more promising. The Americas could easily add ~500/800kbd next year and we need to pay attention to Venezuela because at $80 even BP dares to get in... and that is saying a lot. With Venezuela could be upwards of 1Mnbpd.

Then there is some more from WAF, Libya has a little more to give, Kazakhstan... well, it has potential, but they need to fix a few things first... but everything points to more oil coming from West of Suez. Therefore, it is very likely that in December next year Brent will not be worth $80...

Need a higher return? Refineries can also lock-in an extremely high margin for all of 2027, especially in Gasoil, supported by fundamentals. Those Russian refineries are not coming back in their entirety, even assuming everything in the Middle East gets sorted out, the problem is structural unless we see a substantial drop in demand. Gasoline could be more compromised in terms of consumption, because at these prices we are already seeing some signs of “peak demand” that could put the future of this business at risk, assuming we ever return to normal.

The only problem we see is availability, right crude grade at the right time, however, with the crack spread at two standard deviations above the historical average, there is plenty of room for optionality. Unlike E&P companies, refinery assets are a fixed stock, there is no expectation of new refineries being built, except for Dangote in East Africa, which at these prices he might actually get the financing in place for the new one... some upgrades at peripheral refineries, but upgrades mean shutting down the refinery, and with these margins I find that unlikely... unless they are refineries that are mothballed... again, pay attention to Venezuela, they have 2Mnbpd of capacity sitting idle since the golden days.

Upstream too specialized? Downstream too boring? What about midstream? Is a 50% ROA enticing enough?

This really challenges any logic... in theory, you could buy a VLCC for $130M in January 2027, make six Middle East to China voyages throughout next year, generating $106M in revenue with a ~70M net income. More leverage? You buy the ship with a 30% down payment and finance the rest over seven years at 7%. Even more leverage? You could time-charter the ship for $120k per dayfor a year and sell the entire 2027 at $200k, today, right now...

Sounds very nice, but there is a catch, it is the lack of liquidity in these freight futures. I once tried to do something similar with 10 VLCCs that I wanted to hedge long term exposure... I’m no longer welcomed at the Baltic Exchange since that day. It is true that liquidity has improved somewhat over the past few years, but selling 1,650 lots of Cal27 can be difficult over just a few sessions, although it is not impossible to build a synthetic position with Q1/Q2.

Generally, freight is not reactive, only the front months move, but this repricing of the entire curve, across almost all futures, is remarkable. Who is paying? It is not the majors, because those guys simply buy the ships outright, or acquire them on time charter. Traders are more active in newbuilds and time-charters, which leaves only one player: Asian refiners. Those guys have very good visibility on what is happening in the Middle East, and for a reason, they are hedging.

For those of us in the industry who were thinking about jumping ship (pun intended) and going to trade GPUs, the bond yields or whatever it is the kids are trading these days, stay one more year, is going to be a good one too.

Nothing can derail us… well… almost nothing