From the July 01, 2010 issue of Futures Magazine • Subscribe!

Crude contango widens out

Currently both crude oil and distillate fuels remain in a steep contango, providing a positive economic incentive to store both of these energy commodities. The contango that has been mostly in place since the beginning of the financial crisis back in 2008 still shows no signs of reverting back into a backwardation anytime soon. The oil complex has been oversupplied, resulting in global oil inventories remaining at above normal levels for the last several years. With Europe’s economy slowing as a result of the ongoing sovereign debt issues and the second largest consumer of oil, China, already tightening their economy to mitigate the impact of inflation, it is unlikely that demand will pick up enough to result in the inventory overhang dissipating anytime soon. The only event that could impact the longer term outlook for oil is the current moratorium on offshore drilling in the United States as a result of the massive BP oil spill. But at the moment even this event is contributing to the contango widening as the back end of the forward curve is holding firm relative to the front end in anticipation of a murky forward supply picture for the U.S. market.

In addition to land based inventories growing around the world, floating storage continues to be a viable alternative to storage trades. Current estimates suggest that there are about 80 million barrels of crude oil and 45 million barrels of refined products (mostly heating oil/diesel fuel) sitting on ships in floating storage parked in various places around the world. The economics of chartering a ship for an extended period of time to store oil remain a viable and relatively low risk trade for those that have access to working capital. Oil inventories are still in a building pattern as a direct result of very favorable economics to buy and hold oil in storage. In a world where most markets (including oil) are trading in or above normal daily ranges and are continuously reversing direction, the ability to enter into a low risk storage trade is very attractive. Storing crude oil for six months in floating storage currently (June 1) provides a return of $1.20 per barrel, or 1.6%. If the storage trade was extended to 10 months, the return would increase to about 3%.

For those not in a position to enter into 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 do not seem to be changing anytime soon. The major reasons why oil is likely to remain over supplied for the foreseeable future are:

  1. The combination of a slowing Europe due to the debt crisis coupled with what is likely to be a slowing of the Chinese economy as the government fights inflation all translate to oil demand growth slowing and leaving the overhang in supply and inventories in place for a much longer period of time than most investor/traders have been anticipating.
  2. Current estimates for OPEC production are suggesting OPEC’s May output to be at a 17-month high at a time when more oil is not what the market needs, and
  3. Geopolitics are a concern but not a imminent problem that could change the dynamics of global supply & demand for oil.

This suggests that the oil supply should continue to outstrip demand. "Get it while it’s hot" illustrates how contango has widened.

Chart

In addition to the previously discussed fundamental reasons we believe will negatively impact this spread, the chart shows the contango to be widening, and it may be poised for even more downside going forward. The spread has now breached support at the negative $2.75/bbl level hit back in 2008. Trading the spread from the short side should still have room to depreciate even further based on both fundamental and technical support. We strongly suggest anyone entering this trade to carefully follow the progress of OPEC to make certain they do not announce a surprise cut in production as well as the weekly fundamental snapshots released by the EIA every Wednesday as well as a change in the technicals.

Dominick A. Chirichella is a founding partner of the Energy Management Institute and author of the very popular daily Energy Market Analysis. For a free trial of the daily newsletter please email Dominick at dchirichella@mailaec.com.

About the Author
Dominick A. Chirichella

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