Fed Could Drain the Oil Market’s Tank; At around 394 million barrels, U.S. commercial stocks of crude oil, excluding the strategic petroleum reserve, are hovering around their highest levels since the early 1980s

June 12, 2013, 2:56 p.m. ET

Fed Could Drain the Oil Market’s Tank

By LIAM DENNING

There is a shadow looming over oil prices in the shape of a big tank—and a big central bank.

The U.S. last year posted the biggest increase in oil production in the world and largest increase in U.S. history. But is there a shadow in the form of a central bank looming oil prices? Heard on the Street editor Liam Denning reports.

At around 394 million barrels, U.S. commercial stocks of crude oil, excluding the strategic petroleum reserve, are hovering around their highest levels since the early 1980s.In part, that reflects the shale-led surge in U.S. supply, with domestic production outpacing imports in late May for the first time since January 1997. In its latest monthly report, issued Wednesday, the International Energy Agency forecast U.S. output would top 10 million barrels a day on average this year, up 23% in just two years.

Meanwhile, domestic demand is sluggish. The IEA expects it to average slightly less than 18.6 million barrels a day this year, down for the third year in a row. The trend of Americans buying more fuel-efficient cars and driving less is holding down consumption. Back in 2005, Americans burned almost 21 million barrels a day.

But another factor keeping inventories high has nothing to do with roughnecks or commuters. It emanates from Washington.

Refiners and oil marketing and trading firms keep stocks on hand to ensure they can supply customers. Low interest rates, facilitated by the Federal Reserve’s policy of quantitative easing, make it cheaper to finance those inventories. Indeed, those low rates can make it very profitable to buy oil, store it and lock in a margin by selling futures.

Energy economist Phil Verleger estimates that with short-term interest rates around 0.25%—roughly in line with Libor—the financing cost of holding stocks today is around two cents a barrel every month. Right now, three-month oil futures trade at about a 30 cents a barrel premium to the spot price. On that basis, assuming 90% leverage, an investor could buy oil and sell it three months forward, earning a 2.5% return after costs.

That might not sound like much. But it is five times the yield on three-month U.S. Treasurys and a no-brainer for a trader at an oil firm with access to storage capacity.

But the trade is getting squeezed over time. Back in February, the spread was around $1 a barrel, implying a return over three months of almost 10%. While spot prices have held pretty steady over the past few years, futures further forward have been slipping, likely reflecting rising expectations for U.S. supply and acceptance that the global economy’s recovery will be a gradual, drawn-out affair.

The upshot is that, with bond yields rising as the end of quantitative easing becomes a more realistic prospect, profits on the carry trade are likely to shrink further. The same trade described above at current spreads but with a 1% financing cost earns a return over three months of less than 0.7%.

As this squeeze becomes more apparent, it can become self-fulfilling as those holding inventories sell them in the expectation that futures will decline further. That liquidation adds further pressure to prices as it increases available supply.

Say 50 million barrels were liquidated over the second half of the year, which would simply bring U.S. inventories down to around their five-year average. That would amount to almost 274,000 barrels a day. To put that in perspective, it equates to about a third of the IEA’s expectation for global oil-demand growth this year.

The past few weeks have seen yields rise globally as bond investors raise their expectations of the Fed taking its foot off the gas. Oil investors won’t be immune.