Oil: Shall We Contango?

Lynne Kiesling

Oil prices today are the highest (nominal) prices ever, over $71. Some of the driver of this price increase is uncertainty surrounding Iran. But what’s really interesting from an economic perspective right now is that oil markets are in contango, and have been in contango since early this year. Wikipedia defines contango thus:

Contango is a futures market term. 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.

A contango is normal for a non-perishable commodity which has a cost of carry. (Such costs will be warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (eg. gold)).

The contango should equal 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 (see rational pricing ? futures).

But if there is a near-term shortage, the price comparison breaks down and the contango may be reduced or disappear. Near prices become higher than far prices because for consumers future delivery does not suffice, and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. This is called backwardation.

This Smart Money article explains some of the mechanics of futures trading and contango:

Futures contracts for delivery in a given month expire around the 20th of the preceding month. To prevent an actual delivery ? the typical investor doesn’t really want barrels of oil off-loaded in the driveway ? traders sell the contracts before expiration, thus closing out the transaction. …

This need to swap contracts, closing out and buying new ones every month, creates what’s called a “roll.” Frequently, there’s a difference between the trading price of the futures contract that makes delivery within the next month and the futures contract that expires and contemplates delivery in a later month.

There are different terms for when a later month trades above or below the current one. Take a crude contract in May. If the June contract trades at a price below May, this is a condition called “backwardation.” Conversely, if the June contract trades at a higher price than the one in May, this condition is called “contango.” …

“In an oil contango, if today’s price is lower than next month’s prices, that indicates the crude oil market is well supplied and next month it will be a little bit a tighter,” says Dan Brusstar, senior director of energy research at the New York Mercantile Exchange. “The price is now looking out into the future. And the market expects prices to be more expensive next month because of the supply and demand fundamentals.”

One reason this is interesting is that this contango condition is inducing refiners to buy more crude oil than they can currently process and sit on it, because the carrying cost of the inventory is lower than the expected spot price in the future. According to an article from Tuesday’s Wall Street Journal (subscription required):

Since early 2005, the crude-oil market is in what traders call “contango,” meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.

In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.

“Suddenly, the best use of funds by a company like Valero [Energy Corp.]”, the largest independent U.S. refiner, “is putting money into tanks for more crude rather than investing in facility upgrades,” Mr. Verleger said in a recent report.

Indeed, San Antonio-based Valero has been operating with its crude tanks full since the start of the year. When the market is in contango, “you tend to operate at the top of your tanks,” says Bob Beadle, Valero’s senior vice president in charge of crude oil, supply and trading. Mr. Beadle estimates that in the U.S., the difference between the industry operating at full tanks and at minimum operating levels amounts to as much as 75 million barrels of oil, or about three days of supply.

That’s why even though the weekly US inventory reports have been showing increasing crude inventories for the past month, crude prices are still rising, because a barrel today is cheaper than a barrel in the future, in expectation and including inventory costs.

Oil & Gas Journal reports that natural gas markets are also currently in contango through January 2007.

I find this fascinating, and would like to know what informed folks like James Hamilton think.