For Oil and Gas Storage, Lower Inventories Will Lead to Higher, More Volatile Prices
Here's how to read the forward curve in the oil and gas storage sector.
If the stock market is in fact a forward-looking indicator, we should expect the profitability of storage firms to rise in expectation of a contango and to fall in expectation of backwardation. Do the performances of the stocks in the S&P oil & gas storage index, Kinder Morgan (NYSE:KMI), Spectra Energy (NYSE:SE) and Williams Companies (NYSE:WMB) relative to the S&P 1500 Supercomposite itself give us some warning about changes in the forward curves for both crude oil and natural gas?
Let's map relative total returns for this index against the premium/discount of spot prices for both crude oil and natural gas relative to their respective 18-month strip prices. In the case of natural gas, the lead time is approximately five months. The downturn in storage stocks' relative performance since August 2012 has led the narrowing of natural gas' spot price discount to its strip price.
What about crude oil? Here the lead time is approximately six months; the spot price at Cushing has been trading over the strip price since early March.
The loss of contango in the crude oil market and the resulting downturns in inventories over the past quarter will reduce the supply cushion that has kept crude oil prices in a sideways range over the past two years. Moreover, it will make these prices more volatile as storage reduces price volatility. The effect will not be as strong for natural gas. The difficulty of storing natural gas in commercial quantities assures the storage and terminal operators along with the pipelines and local distribution companies of a continuing market for natural gas storage.
In both cases, lower surplus inventories are going to lead to higher and more volatile prices and to a demand by users for price insurance. That will lead in turn to a greater demand for storage and to an end of the storage index's current cycle of underperformance.
As an aside, not only is too much attention given to weekly changes in inventories for both commodities, but the attention gets focused on prices and not on the forward curve. Investment decisions are not made on day-to-day changes in price; they are made on longer-term changes in industry economics reflected in the futures markets.
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