Contango TKO’d

Boxing

This feels like that time I thought storing oil was a good idea.

The last straw has fallen… the camel’s back is broken. Perhaps the last price support for my beloved West Texas Intermediate has started to lose its luster over the last few days.

You see, the market has been in a state of contango for months. Is contango a new dance craze sweeping the nation you ask?  No! I answer, it’s waaaaaay more exciting than that (for nerds)! It’s almost as fun to say as BACKWARDATION… which is, ironically enough, the normal state of affairs for the oil market.

Instead, Contango refers to a market condition wherein the future (expected) price of a good is greater than the current, or spot, price one can pay today. Traders LOVE contango, because all you have to do is purchase some of that commodity now, store it and reap the benefit in the follow on month when the price will be greater. It’s like printing money!

You see, until pretty recently the long-term futures market (as in, longer than a month) looked okay. One could buy a certain amount of oil today at $45 per barrel, and could lock in a price of $55-60 if they could find a tanker to store the stuff until that contract matured in a few weeks. Literally millions of dollars was being made by this strategy.

But, this demand started to have a follow-on challenge. As more and more people were doing the contango, the price for each unit of storage (on vessels like the ULCC, which is AWESOME) also started to rise. Right now, it cost about $4.65 per barrel just to store the stuff! Which is no problem as long as the traders could get someone to believe in the futures price to lock in that $45-55/ barrel. Unfortunately, it seems that almost everyone is now waking up to the fact that the forward price of oil is not going to rise anytime in the near future… the futures market for contracts extended two years from now is trading at, roughly, $60 per barrel… I can’t even do the math to contemplate how much it would cost to store oil for THAT long. Instead, the futures contract is selling for just a $2.50 premium over the current market price… meaning that anyone doing the contango is just paying a couple of bucks for every barrel they put in transit.

As these spot purchasers ran out of storage space – meaning the storage capacity became too expensive to be economical – they’ve stopped acquiring barrels on the open market. As they stop purchasing, the price support for the spot market is pulled away. As the spot market falls, the front month futures contract declines. As that declines, the forward contracts for the upcoming months will also decline, meaning that price support for the oil provided by the traders is the latest crutch to be pulled from the shoulders of the already wobbly oil markets. (And this is happening with a slightly weakened dollar… As I have argued here and here, I doubt that situation will last for long. If the dollar gains strength – and it will – the price of oil will face even more pressure.)

About Sennoma Civitano

You can trust me. I'm a law-yuh. Oh, and I have a Master's in Public Affairs. I read books. About things.
This entry was posted in Economics, Investing, Oil & Gas, Oil Prices, Uncategorized and tagged , , , , . Bookmark the permalink.

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