The Market's Measure
market's measure

A Convenient Truth

Oil’s glut is getting mopped up.

There’s been a lot of fretting and sweating over oil prices lately. Concern about the petroleum sector heightened even more as Hurricane Harvey bore down on oil rigs and refineries in the Gulf Coast region.

The spot price for a barrel of West Texas Intermediate (WTI) crude has been fibrillating in the $47 to $49 range this month following a dip below $43 in the early summer. Despite the gain, oil has more work to do to regain its previous bullish momentum. The graph below charts spot oil’s history over the last two years. WTI is represented by the black line. The red line, which has pretty much tracked oil’s price through March, represents crude’s three-month annualized convenience yield.

What’s a convenience yield? It’s the benefit—or cost—of holding physical oil versus owning a derivative such as oil futures. 

 

Holding oil as inventory is “convenient” for a refiner when doing so ensures the continuity of distillate (e.g., gasoline and fuel oil) production. When oil is plentiful, refiners can buy oil at will to meet their production needs. Having oil on hand—in storage—pays off when demand for oil heightens and spot prices rise. The convenience yield represents the gross return implied for carrying an oil inventory—essentially, the profit that could be obtained by selling excess crude at market prices.

As the chart above illustrates, crude oil’s convenience yield has been mostly negative since 2015, reflecting a glut in the market. But this year’s trend has been upward. The yield is now very close to zero (at last look, it was -4.16 percent). The yield’s still negative, though far less so than at the beginning of the year.

Look again at the chart and you’ll note that oil’s price trend has been diverging from that of the convenience yield. The yield hasn’t been closely tracking oil’s cost as it has in the past. In other words, the convenience yield is behaving as if oil’s supply is tightening.

In the past, convenience yields have been predictive of both future oil inventories and prices. The market is trying to tell us something here. Savvy traders are likely to heed the message and start looking for opportunities on oil’s long side (see Oil’s a Buy Again).  

Brad Zigler is WealthManagement's alternative investments editor. Previously, he was the head of marketing, research and education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange-traded funds. 

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