Profiting from a contango, not so easy | FT Alphaville

Profiting from a contango, not so easy

Bloomberg calculates that the current contango in crude has reached its steepest for a 12-month forward period since 1998. The news agency writes:

In the worst year ever for oil, investors can lock in the biggest profits in a decade by storing crude. Traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain. After taking into account storage and financing costs investors would earn about 11 percent, according to Andy Lipow, president of Houston consultant Lipow Oil Associates LLC. The premium, known as contango, is the biggest for a 12-month span of futures since 1998, when a glut drove crude down to $10. Stockpiling crude may provide higher returns than commodities, stocks and Treasuries as the U.S., Japan and Europe endure simultaneous recessions for the first time since World War II.

Crude sank 72 percent in New York since peaking at $147.27 in July. The Standard & Poor’s 500 Index fell 40 percent this year and two-year government notes yield 0.9 percent. “The bottom line is that you buy crude at a low price and lock in a profit by selling it forward,” said Mike Wittner, head of oil market research at Societe Generale SA in London. “It’s low risk. The contango can definitely pay for storage and the cost of capital and leave plenty left over.” Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery.

The ship is one of as many as 16 booked for potential storage instead of transporting crude, said Johnny Plumbe, chief executive officer of London shipbroker ACM Shipping Group Plc. Oil Storage The tankers, if full, hold about 26 million barrels worth about $1 billion, more than the 22.9 million barrels sitting in Cushing, Oklahoma, where oil is stored for delivery against Nymex contracts. U.S. crude inventories rose 11 percent this year to 320.4 million barrels, according to the Energy Department. “All the market operators keep placing oil in storage,” said Francisco Blanch, head of global commodities research at Merrill Lynch & Co. in London. “Even though the contango is steep, it could get steeper.”

Crude oil for January delivery rose as much as $1.93, or 4.7 percent, to $42.74 a barrel in after-hours electronic trading on the New York Mercantile Exchange. It was at $42.60 at 12:30 p.m. Tokyo time. Blanch said last week that oil may fall to $25 a barrel should the Chinese economy slip into recession and the Organization of Petroleum Exporting Countries fail to take enough crude off the market. Shell, Koch The Hague-based Shell, Europe’s largest oil company, last month chartered the supertanker Leander with an option to store North Sea Forties crude, according to Paris shipbroker Barry Rogliano Salles. The vessel arrived at Scotland’s Hound Point, the loading port for Forties, on Nov. 20, according to tracking data compiled by Bloomberg. Sally Hepton, a London-based spokeswoman at Shell, declined to comment. Shell and Koch Industries Inc. of Wichita, Kansas, also hired four supertankers to hold oil in the U.S. Gulf Coast to take advantage of rising prices in the months ahead.

They took Very Large Crude Carriers, or VLCCs, to move oil from the Middle East, said Bruce Kahler, a broker at Lone Star, R.S. Platou in Houston. Koch Supply & Trading LP spokeswoman Katie Stavinoha declined to comment. The cost to store crude at Cushing averages about 35 cents a barrel a month, Lipow said in an interview. The cost of financing the crude would also be about 35 cents a month. A trader would have to take ownership of the oil in January 2009 and deliver it during December, according to Nymex rules. Supertanker Storage A supertanker would cost about 90 cents a barrel per month for storage, according to data from shipbroker Galbraith’s Ltd. The amount varies, depending on the duration of the storage. “The economics make sense if you can find somewhere to store the oil,” said Tony Quinn, managing director of Lincolnshire, U.K.-based Global Storage Agency Ltd., a bulk liquid storage terminal consultant. With depots in Europe almost full, “companies don’t have anything else they can do, so are chartering commercial tankers for floating storage.”

That’s all very well. But profiting from a contango is not quite as easy in practice.
Storing oil and selling Nymex futures forward means you have to physically have the capability to deliver the correct grade of crude – that being WTI – into Cushing when the contract expires. Cushing has a limited import capacity. As for the grade, you can’t just buy any type of crude and hold until delivery. West Texas Intermediate is a specific spec. While WTI doesn’t have to be sourced from West Texas, it does have to be blended accordingly to meet this grade. That spec and that spec alone is deliverable into Cushing. This complicates matters somewhat, especially for producers like Opec who would have to lock-in the corresponding blending components to assure Cushing delivery.

As the FT reported in May this year, quoting Commerzbank commodities specialist Eugen Weinberg, Cushing constraints can in themselves be a real problem too:

The West Texas Intermediate oil contract, based on delivery in Cushing, Oklahoma, is good for 300,000-400,000 barrels per day. The storage capacity in Cushing is about 20.5m barrels. The trading volume on which that is based is between 500m and 600m barrels per day. If you are going to manipulate the price, you would think about doing that in Cushing.”

Writing last year in the Middle East Economic Survey, Bassam Fattouh also explained to what degree logistical constraints at Cushing can further perpetuate the intensity of the contango once it’s in place:

It is interesting to note that in the past, the main logistical bottleneck was how to get enough oil into Cushing. In many instances this resulted in serious dislocations and WTI rising to very high levels compared to other benchmarks. The problem is now reversed: while the ability to get oil into Cushing has increased, the ability to shift this oil out of the region and to provide a relief valve for Cushing has been very limited. This situation has led to a larger-than-expected build-up of crude oil inventories in Cushing. According to the EIA data, in the first week of April 2007, crude oil inventories reached 333.4mn barrels, an increase of around 8.1mn barrels compared to the previous four weeks. According to the EIA, more than half of this increase (4.7mn barrels) occurred in Cushing where inventories had reached 27mn barrels in the first week of April 2007.

As a result of this large build-up, the WTI price has been decoupled not only from the rest of the world, but also from other US regions, particularly from the US Gulf. Given the importance of WTI as a benchmark, the effects of these localized logistic problems were widespread and affected the oil price structure in three major ways. First, faced with large stockpiles, oil traders were forced to crush the spot and front-month prices. As a result, the oil for first-month delivery was being sold at a large discount to oil for second month delivery, deepening the size of the near-term contango in the WTI price term structure. Figure 1 shows the size differential between the first-month WTI futures contract to the second-month WTI futures contract (deliverable at Cushing) between 3 January and 17 April 2007. As can be seen from this figure, the size of the differential increased in the month of March exceeding $3 in 19 March. The month of April witnessed a similar trend with the differential reaching $3 in 10 April. The shortage of storage facilities at Cushing contributed further to the deepening of the contango.

Essentially, because oil at Cushing can get bottlenecked – as oil can only flow in one direction to a specific number of refineries – it can get artificially bid down versus other grades in the prompt market. Given the fact that refining cracks are trading negative, chances of minimal take-up verus high delivery demand in the future (due to the contango) could make a bottleneck a real possibility. In that case, anyone selling oil WTI futures for delivery has to account for potential capacity problems at Cushing. The alternative for a seller is netting out and re-delivering elsewhere – perhaps why tanker storage is being favoured over standing storage by some – or rolling the contract onwards. It’s worth remembering, less than 1 per cent of Nymex light sweet crude contracts go into actual physical delivery.

As late as last week, energy company Hess was offering capacity across many of its facilities. But, with the contango most likely the result a glut today rather than a perceived shortfall of supply tomorrow, it’s no surprise some firms see more sense in storing via floating facilities. Rates for VLCCs are currently cheaper than usual (although not as cheap as dry bulk freigh rates) and assure energy firms much more flexibility for delivery.

Of course, for anyone who can overcome all the above variables and potential basis risk – including higher financing costs for the initial spot purchase due to the credit crunch – the contango can indeed be a profitable venture. A completely risk-free money-making enterprise, however, it is not.

Contango term structure - Schork Report
Related Links:
What a contango – FT Alphaville
Is it a bird? No, it’s a supercontango – FT Alphaville