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It Takes Two to Contango

Pullback in Oil Is a Buying Opportunity

Posted June 4, 2008 at 10:13PM

A few readers have asked about the meaning of a term I used in my last column: "contango." So this week, we'll delve into the murky world of oil futures trading.

A crude futures contract, for those who are unfamiliar, is simply a contract to buy or sell a certain amount of crude oil, of a certain specific gravity (ranging from "light" to "heavy") and sulfur content (ranging from "sweet" to "sour"), delivered to a specified place, at a specified price, on a certain day in the future. The contract can be settled in one of two ways:

  1. Upon expiration, the holder of the contract—normally, a refinery—takes delivery of the oil and pays the specified price.
  2. Prior to expiration, the holder of the contract can either sell a long position (effectively liquidating an earlier purchase), or cover a short position (that is, buying a new contract to cancel out an earlier sale), to close out the futures position and its contract obligations that way.

The price of oil futures contracts normally follows a curve, where the price for delivery in the near term—say, next month—is higher than the price for delivery far in the future—say, eight years from now. This condition is known as "backwardation."

Conversely, when the price in the future (a "deferred" contract) is higher than the near-month price, the curve is said to be in "contango."

Traders generally look at inventory levels and anticipated production when bidding on contracts. A tight inventory situation now is expected to be resolved by the market in the future, so prices usually fall off in a long backwardation curve over time. But they might also show a short period of contango for the near future, reflecting the current tightness of the market, as demonstrated in this chart:

Crude Futures Feb 2006

Normally, periods of contango are relatively short-lived, as buyers take advantage of near-term weakness, which eventually restores the backwardation curve.

In May, however, an unprecedented change occurred: the futures contract went into a long-term continuous contango, as shown in this chart by "jeffvail" from his post on the subject two weeks ago at TheOilDrum:

NYMEX Crude Futures '08-'15.jpg

The sharp upward move of the curves between May 16 and May 20 into continuous contango not only happened faster, but rose farther, than they ever had before.

Analysts were quick to point the finger at speculators for the sudden change, calling oil futures a "bubble" and offering lots of complicated explanations to support their arguments.

"Speculation," or Normal Market Behavior?

As I argued on Neil Cavuto's show on Fox Business on Monday (video forthcoming), I think the speculation argument has been really overblown. Likewise, I think the hunting expedition this week in Congress, where they grilled oil market-makers and investors to see if the oil markets were being unfairly manipulated, was a waste of time.

Ultimately, when the contracts are settled, as Scott Nations pointed out in a humorous discussion on CNBC a week ago, "the price is what the price is." It's the refiners who have to take delivery of the black gold who ultimately decide what the fair price for oil is. Upon expiration of the contracts, as Rick Santelli said, "there is no speculation."

The fact that we really haven't seen a wide divergence in price between the middle of a contract and its expiration belies the argument that oil's rise is all about speculation. Although speculators do play a role in that process, the fact that oil is a commodity that will be physically delivered really limits the opportunity to manipulate the contracts—they're not like cash-settled futures.

I firmly believe that what we are seeing in the oil markets now, where crude has rocketed from $100 at the start of the year, to a peak around $135, then falling rather quickly to $122 today, is primarily the simple result of traders trying to figure out what the proper value of a barrel of incredibly useful, energy dense, finite, and diminishing oil should be.

So yes, speculation does play a role in the short-term fluctuations-when oil is up $2 one day, then down $3 the next day, then up $2 the next-but over the long term, it's just the market doing its thing.

By the way, the swing to contango also means that the aggressive oil price hedging strategies that enabled Southwest Airlines to pull the only profit of all the major airlines in Q1 (see my recent article, "Say Goodbye to Cheap Air Travel") relied upon the historical norm of backwardation. If this contango pattern persists, it's going to put the screws to the airlines even harder...and offer some great investment opportunities in rail.

Today, the curve is showing a little backwardation at the front, but is still in a long-term contango:

NYMEX Crude Futures 6-5-2008.jpg

Source: NYMEX

The dip is probably a response to today's inventory report, which showed an unexpected drop of 4.8 million barrels, or 1.5%, where analysts had expected a gain of 2.7 million barrels, according to a survey by Platts. It was the third declining week in a row, and puts inventories about 12% below where they were a year ago, according to the EIA.

Refinery utilization is currently 89.7%, which is lower than where I expected it to be at this time. If inventories are dropping, and refiners are still running at a relatively low rate of utilization at the beginning of the summer driving season, then refiners are probably betting that the market is softening in the short term, so they'd rather draw down inventories and wait and see.

A Simpler Explanation

There may be a simpler explanation, though, than all this gen-u-ine Wall Street gibberish about dancing the contango backwards, or whatever.

It's axiomatic that two primary sentiments rule the markets: Fear and greed.

When the markets are greedy, backwardation rules, and traders can play games like selling the front-month contract and buying the long contract to make money on the difference.

But when the markets are fearful, and the future looks dim, we get contango.

And it just so happens that the startling shift to a long-term contango began in the week of May 19—the same week that the financial media seemed to finally embrace the concept of peak oil. (See my article of last week, "The Tipping Point in the Peak Oil Debate.")

It really might be that simple.

Global demand for oil is still greater than supply, and we believe that it will continue to remain so (with perhaps a few short periods of easing), so we think we'll be dancing the contango for a good long time to come—at least until global demand destruction sets in.

As for the conventional wisdom on the Street, Lehman Brothers and others are convinced that prices are now "anomalous" and that oil is an asset bubble. They believe that global supply will increase faster than expected in the next few years to resolve the tension, and for a while that will probably "talk down" the price of oil.

But I think they're wrong. Non-OPEC supply in particular looks terminally broken to me, and any growth in OPEC supply is dubious, at best.

That means you've got a buying opportunity developing here, while the market is underpricing the future of oil.

Whether you're the kind of investor who might play the United States Oil Fund LP (AMEX:USO), an ETF on oil futures, or a more traditional investor who might seize the opportunity to jump on some of the oil plays we have recommended for the $20 Trillion portfolio, this is the kind of pullback you're looking for during a long term bull run for oil.

Until next time,

Chris

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