As crude oil rallied to unprecedented levels, experts set a moving new floor for crude. First it was $40, then $50, then $60 and eventually $80. Once the correction in crude turned violent, the price curve seemed to indicate that the sell-off was overdone and a deep contango formed along the price curve.
Currently the entire oil complex is in a strong contango and as such storing oil is a very economical trade. Estimates indicate that about 25 ships have been chartered by various players solely for storing oil (about 50 million barrels) while inventories in Cushing, Okla. (the delivery location for the Nymex WTI contract) have been surging, with total storage capacity in Cushing at the highest level in years. With most every investment yielding next to nothing, the oil market is providing a tremendous return for storing oil for those who have the working capital and access to storage facilities. Oil inventories are still in a building pattern because of very favorable economics to buy and hold oil in storage.
For those not in a position to enter this trade on a physical basis, there is still an opportunity to approach the trade using the Nymex WTI contract, as the conditions that have driven the market into a deep contango are changing. These changing conditions will affect the shape of the forward curve and thus provide a trading opportunity. Here are the key conditions that are changing:
• OPEC has committed to cut production significantly. They will be cutting over four million barrels per day out of the supply chain by Jan. 1, 2009 as compared to September 2008. The overhang of oil (resulting in the contango) will begin to subside and inventories will move into a destocking pattern.
• The demand/decline pattern for oil may be approaching a bottom as countries around the world kick-off massive infrastructure projects to jump start the global economy. Most of this stimulus is not only labor intensive but also energy intensive.
• With energy prices at four-year lows in the United States, the consumer may be starting to revert to some of their old driving habits. Over the last month or so, gasoline demand (as estimated by the EIA) is relatively steady.
• Geopolitical tensions are rising in the Middle East once again as the Israeli/Hamas conflict broadens. If this situation continues to deteriorate, it could lead to supply disruptions from the world’s largest supply area for crude oil.
The above suggests the oil supply will not only be moving more in line with demand, it most likely will overshoot the balance with near-term supply likely dropping to levels below near-term demand. The result will be a pull from inventories to meet ongoing supply needs and thus the setting for the forward curve to begin to change shape from a deep contango to possibly a backwardation, especially if OPEC’s resolve to keep production low remains strong. To take advantage of the changing conditions, we suggest looking at the April 2009/March 2010 Nymex WTI spread. We chose the April/March spread to give the trade time to evolve. The April Nymex contract does not expire until March 20, or well after the OPEC cuts will have had time to affect inventories (see “Opportunity knocking?”).
In addition to the aforementioned fundamental reasons we believe will impact this spread, “Opportunity knocking” shows the contango seems to be subsiding and may be in the early stages of a turnaround. The five-period momentum indicator shown on the lower portion of the chart also seems poised for a breakout and may be an early warning signal for a change in direction of the spread. We suggest buying the spread (buy Apr. ‘09/sell Mar. ‘10) in anticipation of the forward curve flattening and possibly moving into backwardation. We strongly suggest anyone entering this trade carefully follow the progress of OPEC to make certain they are abiding by their announced cuts as well as the weekly EIA inventory data released every Wednesday at 10:30 a.m. EST.
While there is some fundamental evidence that the market could return to backwardation, it would be prudent to take profits on this trade well before that occurs. The correction that occurred in the first part of December involved a $4 move in the spread.
Dominick A. Chirichella is a founding partner of the Energy Management Institute and author of the Energy Market Analysis newsletter. For a free trial of the daily newsletter, please e-mail Dominick at dchirichella@mailaec.com.
