Super Contango
| Tue Jan. 13, 2009 9:27 PM PST
SUPER CONTANGO....Normally, it costs more to buy a barrel of oil for delivery six months from now than it does to buy a barrel of oil today. After all, if you're not going to take delivery of my oil until July, then I'm going to want the spot price of the oil plus the cost of storing it plus the cost of having to wait for my money. So maybe a barrel of oil that costs you $38 today will cost you $41 for delivery six months from now.
But instead of $41, what if the July price is $53? Then anyone who wants to can make a guaranteed killing. Accept the contract, buy a tankerful of oil, store it for six months, and then deliver it. 
Even after the cost of storage and the interest on the loan you took out to buy the oil, you'll make a quick and easy twelve bucks per barrel profit.
Sounds nice, but since this profit opportunity is so obvious it should get arbitraged away almost instantly. In short, a situation like this should never happen — certainly not for long periods, anyway. But it has:
On Monday, oil for February delivery closed at $37.59 a barrel on the Nymex, or nearly $15 lower than July's contract price....Such a distance between contracts is unusual, sparking industry insiders to term the phenomenon — which reached an apex in late December — "super contango."
When the price spread is greater than the storage cost, "there is an opportunity to arbitrage at a profit without risk," said James Williams, an economist at energy research firm WTRG Economics.
So what's going on? One possible explanation is that most of the easy storage is already full, so it's not really possible to make a quick buck on this even if you want to. But even if that's the case, there's yet another option: oil producers can pump less oil now (essentially "storing" it in the ground) and then pump it out in July for delivery at the higher price. But apparently they're not doing that. John Hempton figures there are two possible explanations: (1) they're already pumping at full capacity, so they can't promise to pump extra oil in July even if they want to, or (2) oil producers are so desperate for cash that they're willing to take money now even if it's way less than they could get for the same stuff six months from now.
#1 doesn't seem to be true. So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now. Either that or else there's an option #3 that's not obvious. Any ideas?
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Comments
The price of storage is going up. Right now VLCC owners are charging $70,000 per day for storage in the gulf. That's about 6.5 dollars a barrel for 6 months storage. There goes half your profit and we haven't addressed loans, piracy, and the second party going bankrupt.
As to keeping it in the ground and pumping later I think the wells, pipelines, and global tanker fleet have their own bottlenecks. Besides, Saudi princes need the cash today.
Submitted by Scott Forbes (not verified) on Tue Jan. 13, 2009 11:50 PM PST.
For sellers of oil, the rational decision is to stop selling oil in February, borrow enough cash to stay whole, and then sell in July. In a normal credit market this would happen immediately: All sellers would stand pat until the February price of oil rose to about $49 or so.
But there is no credit.
The global financial system, which allows sellers to raise capital and take advantage of arbitrage opportunities, is temporarily (?) out of service. Sellers are unwilling to draw down their cash reserves while they lack easy access to credit (and while jittery investors are waiting for the signal to run screaming for the exits), so the sellers are effectively locked in: Their only means of raising capital is to sell oil, which limits their ability to close the arbitrage gap.
On the other side of the table, where each barrel of oil comes with a free $10 bill, everyone who can afford to execute a buy-and-hold strategy is emptying their pockets like mad - but, collectively, their pockets aren't deep enough. If they had access to capital, they'd borrow more money and keep buying oil until the gap closed - but they don't have access to capital either, and the number of individual buyers isn't growing fast enough.
The volatility of oil prices created this situation, but it's the absence of credit that keeps the market from returning to equilibrium.
Submitted by Scott Forbes (not verified) on Wed Jan. 14, 2009 12:11 AM PST.
Also, to Simplicio's point, people who buy "future oil" have explicitly decided to pay someone else to buy oil and store it for them (and/or to take the risk that oil prices might rise in the interim, but that's not the situation at hand). I'd suspect most July buyers are not well positioned to bypass their middlemen and stock up on oil for later; those who can, probably are, but they'd be a vanishingly small percentage.
It's not just the Saudis who need money. Chavez had to rein in a lot of his foreign political activities in South other American countries like Bolivia and if I remember correctly recently almost cut off his subsidization of cheap home heating oil for 200,000 US citizens.
Gazprom didn't pick the absolute worst time (again) to shaft their own customers in southern Europe over $2.6 billion in unpaid bills from Ukraine to deliberately prove
they're an unreliable supplier. They did it because their majority owner the Russian government really needs the money.
Your scenario of "saving" the oil in the ground doesn't make any sense. It's not as if producers only have 1 month's supply of oil and are choosing whether to sell it today or in 6 months. Rather, they're selling oil today and they will be selling more oil in 6 months.
Your conundrum is like wondering why, if there's a predicted shortage of computer programmers coming down the pike, with predicted salary spikes, then why don't computer programmers stop working now and store their labor, waiting to sell it at the higher salary level later.
And, from the commentary I've read, the price spread is feasible precisely because there's no short term storage available--a bunch of supertankers have been pulled offline and leased simply to store oil, and a number more are being bid on for the same purpose. But for most practical purposes, there isn't any cheap, easy to access short term storage.
I think it's a combo of 3 things, Boronx's point (counterparty risk), Scott Forbe's point (lack of sufficient credit to arbitrage it away) and a third somewhat related point. The third one is that financial services companies are some of the largest players in the arbitrage markets. Now that they're hunkering down and focusing on core business they don't have the money, credit or bandwidth to play the game.
Wasn't there as much or more storage then?
Same amount of potential storage, different amount of oil in it. Read the article Kevin linked to.
I really doubt liquidity has anything to do with it. The Saudi's, the Chinese, and Exxon are much better positioned with cash than the rest of the world.
I do question what happens in 6 months if the price of oil is the same and the hedge funds buying petroleum futures have already been absorbed by TARP.
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Saudis have massive liquidity problems.
The fundamental issues at the moment are:
- storage is expensive, and full (hence filling oil tankers with oil, very expensively)
- no one will finance arbitrageurs wishing to store
A related problem, perhaps, is that international prices are decoupled from WTI prices because the oil hub in OK is not connected to the world market to a significant extent (physical limitations on imports and exports).
Note today's news, Saudis have cut production by 2.2m b/d, 300k b/d more than they had promised.
In the previous price crunch in the 90s, other producers exploited this by increasing production, but I doubt the spare capacity exists now.
The world oil price is just another measure of the slump in the world economy that is taking place: less driving, less plastics etc.
Submitted by Carl Nyberg (not verified) on Wed Jan. 14, 2009 8:30 AM PST.
Kevin, your analysis assumes the value of money is constant.
If you add enough inflation into the equation, taking less now is better than taking more later.
Submitted by Maynard Handley (not verified) on Wed Jan. 14, 2009 12:09 PM PST.
" So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now."
Without being snarky here, this seems strange, because it seems like exactly the situation that finance is supposed to help with - borrow using bonds secured against the oil in the ground.
While I imagine that plenty of people wouldn't trust a Nigerian government bond no matter what the hell it claims to be secured against. most of OPEC seem like reasonable credit risks --- especially if the bond is not a debenture (unsecured) but is specifically secured against a real asset.
Obviously, yes, there is less free cash than there used to be, there is political risk, blah, blah. But the numbers here are huge compared to the risks, which makes this as a full explanation seem problematic.
number 3 (no claims for plausibility)
Maybe Saudi Arabia is punishing other petroleum exporters.
Let's pretend that they have spare capacity, and that they are pumping oil at a loss now (compared to keeping it in the ground). This can make sense (roughly anything can make sense) as a punishment for other petroleum producers who over-produced export quotas.
Or maybe they are trying to influence the Iranian Presidential election. Low oil prices are bad for Ahmadinijad. If they want him out and have plenty of money, well they will want to drive down the price of oil.
"Normally, it costs more to buy a barrel of oil for delivery six months from now than it does to buy a barrel of oil today."
Wrong. Normally, it costs less to buy a barrel of oil for delivery six months from now than it does today. (backwardation). Here's why: If I'm an oil producer, and I see higher prices in six months, then I'll leave my oil in the ground now, extract it later. Less supply now and more supply in six months means a higher price now and a lower price in six months, arbitraging away the "soft contango" that you call the normal state of affairs.
Additionally, if I'm a buyer of oil, I could buy oil for a given price right now, and be relatively certain that's the correct price. If I'm buying oil for six months from now, and locking in a price today, I'll be less certain the price is "correct", and will want to be compensated for the risk I'm taking on, which means I'll get a discount (attenuated by the cost of storing that oil) off today's price, all other things being equal.
