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.


  1. My guess is that inventories are bloated and there is a limited physical space available for storage. All of the long players in the futures market realize that they cannot take delivery and are paying large premiums to exit the position.

  2. You description of contango is an accurate depiction of the dynamics that go into pricing different delvery periods.

    The conclusion is not fully accurate. The storage for delivery of benchmark crude (WTI) is limited. It is currently near capacity. This is not an unusual event. Given that OPEC (and Non OPEC) are shipping less oil the market value of leasing tankers has fallen. Since conventional crude storage is full the market is now pricing a new (and higher cost) form of storage, floating tankers.
    the same arbitrage is occuring around contango pricng, only the price structure is higher.

    It's correct to say that the market is currently over supplied. However the decline is tanker cost is telling you that production has been cut. The over supply is being absorbed by the market contango. The impacts of supply cuts has yet to reach the market

  3. Nice post on contango, and I agree with our position that once the storage capacity if fully utilized, there will be a further drop in price.

    But that train of logic doesn't explain the entire price structure. First, why is Brent crude trading at a premium to WTIC when it normally trades at a discount? If there was artificial support for the front month coming from storage demand, then shouldn't WTIC trade at a premium to Brent? (see Mish's blog for some Brent/WTIC spreads

    Second, why is there super-contango in the first place. Or more specifically, why are later-dated futures for crude trading at such a premium? If the demand for crude has actually plummeted, forcing the price down, then why are the later-dated futures prices dropping as well?

  4. Hi. Oil analyst here. You've got something wrong or maybe the language you are using is not accurately communicating your thoughts.

    The oil that is being placed in storage by speculators who are playing the contango (this is the core subject of your article) is not available for sale, and cannot "flood" the market. It is not released to the buyer until the delivery date of the future contract.

    You wrote: 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.

    The market does not become flooded with stored oil when that being stored for delivery in say August of 09 or December of 09. That oil on the contrary is held off the market.

    Problem in your understanding, or in your description?

    Perhaps you think this oil will flood the market in December of 2009. Or some other month.

  5. One additional thought. I would not go to Mike Shedlock for an insight on the oil market. On deflation, credit, and the economy, sure. But not on oil. He has shown himself to be out of his depth on oil many times, and is revealed here similarly. He has completely confused cause and effect in both the contango in WTI and in the secondary relationship to the spread between WTI and Brent. No, he does not provide a "great" explanation.

  6. Oil analyst-

    I do mean it will flood the market at some future date. This is also why I believe there is artificial demand at this current price... without the demand coming from storage, prices would be even lower.

    Thus, I do agree with the Mish post in the following matter. At the point when there is no longer room to store the oil, then all future supply will hit the market, rather than the market and storage. This will out downward pressure on oil.

    His post makes the case that there is more excess storage for Brent crude than for WTIC, THUS there is more overall demand for Brent then for WTIC because Brent has demand coming from end use + storage, while WTIC just has end demand as all the storage is filled.

    Make sense or is this thought wrong?

  7. Makes sence to me. Guess there will be some hard times ahead for the oil producers...

  8. A price crash is too predictable. Maybe adjustment by soaring the spot price and declining forward futures.

    you have to refine the crude that is stored.

    plus, why do we have to correct the contango? equilibrium is for economists.

  9. Interesting, So how does this relate to the price of petrolium being on the increase for the last 50 days or so in the us?

    Is there a relationship between Jp morgans "floating storage" tactics and the rising petrolium prices?