Contango In The Crude Oil Market

The US EIA released crude oil inventories and…..surprise, surprise, inventories were larger than expected. (Insert sarcastic scoff here) The mechanics in the oil market have created an incentive to store oil and sell it in the future. The contango, or what some have deemed “super-contango”, in the oil markets have the tank farms in Cushing, OK at extreme levels. Storage space is so tight that speculators are chartering VLCCs (Very Large Crude Carriers) as floating storage tanks.

Looking at the weekly inventory data from Cushing, OK, or as the EIA so bureaucratically calls it PADD 2, it is clear to see the dramatic increase in oil storage beginning in November 2008.

The blue lines on the chart above indicate the average inventory for any given month - they can be thought of as average inventory bands. It is fairly obvious that the inventory levels in Cushing are well above the averages and do not appear to be abating.

The culprit is contango. Funny name, BIG implications. As a refresher, contango occurs in the futures market when the near month contract is trading below the far month (typically 1 month and 12 month). Currently WTI crude oil for February 09 delivery (CLG09) is trading at $44.96, while WTI for December 09 delivery (CLZ09) is trading at $59.60. This means that investors can purchase oil for delivery in February, store it for 9 months and realize a profit of $14.64 per barrel, less storage and financing costs. Isn’t financing what got us into this economic mess in the first place?

It is, indeed, and it is also why the contango is so large at this point in time. Normally, speculators would arbitrage away any excess gains that could be had by playing the oil curve. However, many of those same speculators cannot get the financing due to the ongoing credit crunch. What’s more, those who can get get the financing are having a tough time finding storage. The result is “super-contango”, which, much like garlic, can have lasting effects. The most extreme could be oil producers shutting in production and using it as “in-ground” storage.

The most logical extension of these developments would be that the supply destruction, or hoarding for storage, will cause shortages, the nearby oil contract will rise and holders will sell stored oil at higher prices. And once again the speculators will be blamed for rising oil prices.

The other extension is that the world will be well supplied with oil due to inventory stockpiling. Spare oil available for storage implies the product is not demanded. When demand rises,those storing oil will supply the market. This, coupled with OPEC’s spare capacity, should keep oil at low levels for some time.

During the recent spike in oil, OPEC increased oil production to levels not seen since 2003. In fact, a casual look at the relationship of spare capacity to the price of oil reveals the price of oil falls as capacity rises.

Prior to the ginormous price move from 2004 to 2008, OPEC’s spare capacity dropped precipitously. From April to August of 2004, spare capacity dropped from 2.29 to 0.71 million barrels per day. The average price of oil subsequently rose from $34b/bbl to over $130/bbl. Between July and November 2008, OPEC spare capacity surged from 1.22 million barrels per day to 2.54 million barrels per day…and oil dropped like a stone from $130/bbl to below $40/bbl, without a hint of resistance.

The bottom line - even if the global economy begins to expand (a huge assumption given recent data) there is plenty of oil in storage and in the ground to supply the market. It is unlikely that a new bull market in oil will begin any time soon.

Disclosures: None

Posted in Categories: Commodities, Contributor, External Research, USA.

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