Friday, January 16, 2009

Oil Tankers are a Banks Best Friend

According to Wikipedia, contango is:

a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be "in contango" (or sometimes "contangoed").

Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery.

How large "should" this contango be? Back to Wikipedia (bold mine):
A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold). The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a risk-free profit too.
Based on this expectation, the current contango witnessed is EXTREMELY excessive. As of the latest figures, contango (as measured below by the spot rate vs. the futures rate 6 months out), the difference is ~15% annualized. This against some of the lowest short-term financing rates we've seen in years (i.e. this is a huge arbitrage opportunity).

Why does this contango exist? My theory is oil producing countries NEED money (budgets were based on $60, not $30 oil) so are willing to sell at whatever the current market price is. And speculators / arbitragers are willing to buy at this price knowing they can sell for a higher amount in the futures market and deliver that oil when / if necessary. This tells me that there is actually artificial demand even at these low prices (from those storing vs. those using the oil) and prices can / will go even lower once storage capacity is completely filled as the market becomes flooded with this stored oil.

And this is exactly what is happening (per Bloomberg):
Morgan Stanley is seeking a supertanker to store crude oil, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, four shipbrokers said. The bank has yet to find a suitable vessel, said one of the brokers, all of whom asked not to be identified because the information is private. Carlos Melville, a spokesman for Morgan Stanley in London, declined to comment. “There’s a lot of people looking for storage,” Denis Petropoulos, London-based head of tankers at Braemar Shipping Services Plc, the world’s second-largest publicly traded shipbroker, said by phone.
Update: Mish has a great explanation for the current dislocation between WTIC and Brent Crude.

As long as storage is available at Cushing -- and given the steep rise in inventories reported by the Energy Information Administration today, storage clearly has been available -- excess oil will go to where it is easiest to take advantage of the contango structure in the market. The eye-popping contango of almost $13/b between February and August WTI is a direct result of the overhang of oil on the market, and the fact that there was available storage at least through last week brought the world's excess oil overhang.

With 32.182 million barrels now sitting in Cushing, the market appears poised to test the limits of storage capacity there. So it's WTI that's reflecting what is going on in the world: the collapse in demand, oversupply and a resulting enormous contango that is encouraging storage. On this one, WTI is ahead of the curve, not behind.