Monday, January 12, 2009 3 comments ++[ CLICK TO COMMENT ]++

Super contango in oil may hurt oil bulls

I'm bearish on oil but if you are bullish on crude oil and thinking of buying an ETF that tracks crude oil, such as USO, OLO, or DXO, be careful. The oil market is in super contango right now:

Futures trading on the New York Mercantile Exchange indicated that a barrel of oil might fetch a much higher price in a few months. At Friday's closing, crude for July delivery was more than $13 higher than February crude, a gap that's never been seen between the two months' contracts.

Contango, or the situation where the price of a far future delivery commodity is higher than a nearer future contract, isn't surprising, with price difference typically representing the cost of storage and the time value of money.

But when the price spread is greater than the storage cost, "there is an opportunity to arbitrage at a profit without risk," said James Williams, an economist at energy research firm WTRG Economics. "Typically contango leads the storage buildup," he added.

Contango is the normal scenario for most commodities. What is unusual now is that the gap between spot market prices and distant futures prices is quite wide. As the article mentions, this presents an opportunity for professional arbitrageurs to profit.

Now, if the arbitrageurs are profitting, who is on the losing side of the trade? Well, consumers of oil indirectly take the opposite position so they would be the "losers" in some sense. However, there is another party that will lose. Those are the investors who invest in index funds that continuously roll over the futures contracts. As the futures expiry date approaches, these investors will essentially sell the contract they have (close to the spot price) and buy a more distant contract that will expire much later (at the distant futures price.) As long as the gap remains large, it is possible for them to lose as much as 10% each time the contract rolls over, every month (or 3 months or whatever the contract length is.)

If you are superbullish on oil and think it will go up 100% in an year (say from $40 to $80) then this may not be a big cost for you. But if you only expect oil to go up 20% then this can eat away all of your gains. So, if you want to go long crude oil, you need to figure out if you want to absorb the roll-over costs, or if you should wait for the contango to shrink. In my opinion, the super contango is unlikely to persist for a long time.


3 Response to Super contango in oil may hurt oil bulls

January 12, 2009 at 6:05 PM

What will be the catalyst that finally ends this extreme state of contango? Further cuts by OPEC, in the face of enormous budget crunches in the petro-states? Exhaustion of all available storage space? I am a long-term oil ultra-bull, but I have refrained from investing in the 2x ETN due to the roll costs. Oil at $250, by way of what? $25? $13?

January 12, 2009 at 7:13 PM

I'm bearish on oil so you are not going to like my answer :)

I'm not an expert on futures or oil but my guess is that the futures price will fall as these contracts get rolled over and we move forward. Ignoring the passive investors, an investor looking at buying a futures contract (long) would be less likely to go long at high (future) prices.

The OPEC budget situation is exaggerated in my opinion. It wasn't even 4 years ago when all these countries had ample money. It's hard to imagine that the budget situation would have altered so much in 4 years that these countries would be bankrupt at $30 or $40 oil. Another thing to keep in mind is that the strengthening of the US$, along with decline in production costs, means that their profits will be strong.

Even countries facing problems like Russia should be in better shape than widely assumed. The massive plunge in the Ruble hurts Ruble-denominated assets but helps the government and the oil & gas exporters.

January 15, 2009 at 12:01 PM

Morgan Stanley agrees with your observation about the oil contango:
bloomberg article

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