Oil Futures in Full Contango
Now I’m not an expert in the oil futures market but I think something significant happened today. For the first time on the New York Mercantile Exchange the futures price of Light, Sweet Crude Oil was in full contango. Contango is a condition in which distant delivery prices for futures exceed spot prices. This means that the closest dated future is the cheapest of all future contracts; all the contracts out to Dec 2010 are more expensive. I believe this has never happened before.
Oil for future delivery is usually cheaper than oil for immediate delivery. There’s usually little point in buying oil today that won’t be delivered for years to come, you’d be better putting the money in the bank and earning interest. Unless that is you though oil was going to be scarce (and more expensive) in the future. Buying future oil contracts today is an insurance policy against future price rises. Airlines tend to ‘hedge’ as much as they can so they know the price their fuel will be in the future and to minimise the pain of short term price spikes. Of course the cost of this insurance is that they are spending the money sooner rather than later and are unable to invest it in the business. When airlines are in financial trouble their oil hedge is one of their most liquid assets and first to be sold off – rendering them more vulnerable to oil price rises in the future.
It is a really strong effect because just a couple of months ago the further-out months were as much as four or five dollars less than the front month. It can only mean that the market thinks that oil in the future will be higher than it is at present.
Hence it will dawn on the producers that oil in the ground is worth more than oil they pump.
So they will be tempted to leave more oil in the ground.
So near-term prices will rise,
So far-out prices will rise.
So they will be tempted to leave more oil in the ground.
So near term prices will rise…
David Fleming
It appears that a significant number of oil traders and investors now believe oil is as cheap as it will ever be. Today they are happy to buy oil at $53 for delivery next month, $56 at for delivery at the end of the year and still $56 with delivery in the middle of 2007.
This prospect means that there is more and more incentive for producers to do less and less. I have a feeling that there will be a contango-led creep of rising oil prices, but that this will be disrupted at some time by a crisis, such as King Fahd’s death or hurricane damage which raise prices to a higher platform from which prices will creep yet further. I think that now is the starting point of serious instability.
David Fleming
Does today mark an important point in the slow awakening to peak oil?
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David Fleming is the author of The Lean Economy: Survivor’s Guide to a Future that Works (forthcoming).
This post was written by Chris Vernon
This entry was posted on Wednesday, June 8th, 2005 at 8:36 pm and is filed under Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
June 10th, 2005 at 12:28 am
I entered into 4 contracts (my first ever financial instruments trade of any type) about 6 months ago, as hedging against a global downturn and losing my lucrative IT consulting job…
Today, almost US$60k profit later, I think it goes beyond contango… there is a trend here: distant futures are increasing in value faster (for the most part) than near-term contracts.
If the tred continues, within about 4-5 months, each month will be priced higher than the preceeding month, and the expectation of peak-oil affects on the market will nop longer be debatable…
June 10th, 2005 at 5:10 am
Right now I’m looking at http://www.nymex.com/jsp/markets/lsco_fut_csf.jsp and I don’t see what you are talking about. Prices peak around 12/05 and fall off all the way out throuh 2010.
Are you adding in some sort of additional cost for physical delivery?
June 10th, 2005 at 8:04 am
Although prices do fall off from a peak (today of $57.67 for Jan 06) the Dec 2010 price is today $54.80 compared with July 2005 price of $54.31. The future cost is higher than the nearest cost in absolute terms before even considering interest rates and the future value of money.
June 11th, 2005 at 3:39 am
Mr. fleming,
Contago is the NORMAL state of futures market. It is hardly rare. Here’s some explaination from intitutional advisor Donald Coxe taken from page 17 of the May issue of Basic Points:
Backwardation refers to a commodity price structure where the spot price is the highest price, and prices decline the further they move into the future.
The opposite of that is the contango, the traditional commodity situation, where the spot is the lowest price, and the futures prices are higher than the spot price. In many commodities, the prices move upwards on the curve in line with the Eurodollar costs of holding inventory.
Almost the only way to get backwardation on a multi-year basis in a bull market is for producers to sell forward. When speculators sell forward, they are assuming substantial risk. Had they been selling oil and gas (and for that matter, the metals) since 2001, they’d have become as populous as whooping cranes. Producers sell forward what they know they will be eventually producing, thereby assuming only an opportunity cost risk (and a mark-to-market accounting risk on futures contracts outstanding after the end of an accounting reporting period).
Heavy shorting by the commodity hedgies, combined with the heavy shorting of the oil industry’s hedgehogs (see p. 20) meant that the highest price for oil would always be the spot price, and that the forward curve would show declining prices for months and even years. That pricing structure naturally meant that refiners and consumers would always maintain the lowest possible level of inventories, because the cost of holding crude could be precisely calculated.
Conversely, when the hedge funds and most of the oil companies took off their forward short positions, the curve swung into contango, with prices strongly upward-sloping. That meant refiners and consumers were being paid to hold excess inventories. Result: US oil inventories rose for 14 straight weeks. To casual observers, this proved oil was in vast oversupply.
To us, it meant that oil had been taken out of the forward curve and placed in inventory. Rather than relying on buying oil cheaper in coming months because the curve said prices would keep falling, consumers were building inventories, thereby saving money.
The general rule is that it costs 50 cents a month to hold a barrel of oil in inventory. Therefore, as long as the forward curve is priced higher than 50 cents a month, the consumer is financially ahead by holding excess supplies-the exact opposite of what was a winning strategy for two decades. Bonus: those extra barrels of oil held for less than zero cost provide a hedge against any of the possible catastrophes that could send oil sharply skyward, such as a successful Al Qaeda attack on Saudi Arabia or Abu Dhabi, or all-out civil war in Nigeria.
This discussion of the impact of hedge funds on commodities and commodity stocks is background to our argument that the modest market capitalization of commodity stocks (other than the super major oils) makes them particularly susceptible to big sell offs when hedge funds change their bets on the outlook for the US and/or the Chinese economy
September 3rd, 2007 at 4:41 pm
I have bought Calendar Spreads - during Contango.
Near month maturiy is Sept. 2007.
Should I roll over to new positions - or wait till the backwardation ends.
We having MTM losses !