Oil market outlook: When contango trade unwinds

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The West Texas Intermediate (WTI) crude oil market went into contango back in June 2008 and reached an apex supercontango in late December. (Fig. 1) Since then, investment firms, investors as well as producers have been stockpiling oil and booked a record number of vessels for storage, seeking to profit from the contango effect in the oil market.

In fact, the WTI futures curve serves as a good indicator of the US oil inventory levels since a contango typically coincides with higher inventory levels and vice versa. The latest inventory data certainly can attest to this relationship.
Bursting US inventory

In its most recent weekly assessment, US Energy Information Administration (EIA) data show a surprising rise in petroleum stocks of 3.7 million barrels from the previous week despite freezing temperatures across Europe and the US in recent weeks (Fig. 2).

At 331.0 million barrels, US crude oil inventories are above the upper limit of the average range for this time of year. The aggregate inventory rise of 8.9 million barrels is also among the largest weekly aggregate increase ever.

In addition, FT.com reported that the US strategic petroleum reserve is now full as of Dec. 27, 2009, adding to the already bearish tone in the market.

Costs and profits

Contango trade is profitable if the spread is wide enough to cover the costs of holding crude stocks, namely storage and working capital. Such stocks are discretionary stocks built or drawn in response to prices, and particularly in response to the forward price curve.

Discretionary stock building occurs “disproportionately” in the US Northeast, particularly around New York, and in Northwest Europe, especially in the Antwerp-Rotterdam-Amsterdam (ARA) area where the world’s two active product futures exchanges, the NYMEX and the International Petroleum Exchange, are based.



A 26-mile long oil contango trade

With on-land tank farms getting full, the discretionary stocks turn to oil tankers for floating storage. According to research by Gibson Shipbrokers, one in twelve of the world’s largest crude oil tankers are being used to store oil rather than transport it.


Bloomberg gave a good visualization of this massive convoy:

“Those storage tankers, if lined up end to end, would stretch for about 26 miles, enough to blockade the English Channel.”

More than half of the ships are in European waters, with the rest spread out across Asia, the US and West Africa. Royal Dutch Shell Plc (RDS.A), BP Plc (BP); Goldman Sachs Inc. (GS), JPMorgan Chase & Co. (JPM); and Morgan Stanley were among those that sought vessels for storage.

145 Tankers and 127 million barrels at sea

By one estimate, the crude oil stored at sea is enough to supply the 27-nation European Union for more than three days.

Shipbroker SSY estimated offshore worldwide there are a total of about 145 vessels holding roughly 127 million barrels of crude oil and oil products at the end of December 2009. That is down from 161 ships with 141 million barrels in November.

Oil crash by contango trade unwind?

Attractive contango spread tends to incentivize traders to buy up spot and nearby futures, which inadvertently narrows the spread (Fig. 3). (Read more on what a flattening oil contango means here.)

The spread between the first and sixth Brent crude-oil contracts on ICE Futures has declined by around 4% from 23% a year ago, and the spread to January 2011 is only around $7. The spread for heating oil also shrank to a low of around $2 from about $18 a ton in December.

Since oil storage trade is no longer as profitable, these tankers are expected to start offloading oil en masse. Based on the median estimate in a Bloomberg News survey of 15 analysts, traders and shipbrokers, about 26%, or 39 million barrels, of the stored crude and oil products could be unloaded from offshore alone in the next six months.

One could only speculate on at least some offloading from tank farms as well.

This is when some analysts predicted the eventual storage trade unwinding could lead to a $10 oil scenario. Lower demand forecasts for oil by various agencies and analysts only add strength to the prediction.
Is the crude market destined for a crash by the contango trade unwinding?

In order to answer that, we need to first take a look at the current crude price dynamics.
Where are oil prices going?

After spiking to a 15-month high of above $83 per barrel owing to freezing temperatures across Europe and the US, crude oil for February delivery settled at $78 a barrel on the NYMEX last Friday – the lowest settlement since Dec. 23. Futures fell 5.7% in one week, the first weekly decline in five weeks.

Now, one of the biggest questions of the market is “Where are oil prices heading?” as no other commodity impacts the global economy as much as the price of oil.

Crude was weighed down by forecasts for weak demand by the International Energy Agency (IEA) and some disappointing US earnings and economic data. Stronger dollar, forecasts of milder temperatures, and moves by China to stem the expansion of the world’s fast-growing economy also affected crude futures.
A crude technical correction

Still, by looking at the current crude oil price levels, one would think there is a shortage of supplies. But nearly all market indications and forecasts are quite to the contrary.

So, technically as well as fundamentally, oil prices are set for a correction as the cold weather abates and the reality of weak demand and high inventory sets in.

Oil volume in electronic trading on the volume totaled 645,000 contracts last Thursday, 14% above the average of the past three months. Open interest was 1.35 million contracts, the most since July 11 2008, the day crude oil reached a record $147.27 a barrel.


Meanwhile, the inverse correlation between oil and the dollar, which had eased briefly, seems to have resumed in recent sessions.

Currently, most of technical indicators are pointing downwards (Fig. 4). We could see crude trading with high volatility, inversely with the dollar, testing the $77/b level with strong technical indicators pointing to around $74 and then we could see $73 tested.

Long live the contango trade

A narrowing contango is typically perceived as a bullish sign for the oil market. The market correction along with continued optimism about global economic recovery could mean market participants will take it as a signal to go back into the oil storage trade.

Other factors also also underpinning the contango trade:

The Federal Reserve will likely keep interest rates low, curbing financing costs for those storing cargoes.

The much-worrying CFTC position limits proposal does not seem as bad as the market had feared.

Weak dollar and inflation hedge should continue to encourage investment in commodities such as crude oil.

“Storage interest is still there”

In addition, a portion of the discretionary stockpile is long term and strategic in nature, and thus tends not to respond to the futures curve as some may expect.

Based on a report by Platts dated Nov. 24, 2009, traders indicated storage interest, though not as strong as before, is still there. Morgan Stanley has chartered a newly built supertanker to possibly store up to 2 million barrels of diesel/gas-oil to be delivered by the end of last November.

In the same report, Platts also noted broker reports showed 16 very large crude carries (VLCCs) have been taken by charterers such as Royal Dutch Shell (RDS.A), Barclays Capital (BCS), Vitol and JPMorgan Chase (JPM) to store diesel/gas-oil off European and Asian coasts.

Boon for tank farms

Oil inventories in the most industrialized countries remain well above average as global demand declines for the first time in a quarter of a century. And based on the latest EIA forecast, global oil stocks are expected to remain in the upper range of the five-year average through 2011. (Fig. 5)

According to FT.com, with high demand for storage space, owners have gained pricing power. In some cases storage operators are even turning away clients.


Most land storage capacity is held by oil majors and state-owned producers or in strategic government reserves. But a quarter is run by independent storage companies that rent out tanks to outside parties.

Some storage operators have even joined the futures trade themselves. Plains All American Pipeline (PPA) uses its 57 million barrels of storage for both lease and “contango market storage activities”, according to its quarterly report.

Storage demand has also been boosted by new environmental rules that require blending of oil products with biofuels, multiplying the number of separate tanks necessary to serve consumers.

Tanker sector hit by glut

The floating storage demand helped prop up tanker rates in 2009, but analysts estimate that the unwinding of oil storage trade would add to vessel supply and push rates for supertankers down more than 25% to an average of $30,000 a day in 2010. That would be below the break-even point of some ship operators such as Frontline Ltd. (FRO), who said its supertankers need $32,900 a day to break even.

So far, current prices for forward freight agreements, or FFAs, suggest the average tanker rate for 2010 will come to $36,000 a day, down from $40,212 at the end of 2009, but still higher than the average $23,130 last year.

Meanwhile, the global tanker fleet is expected to expand by about 12% next year, 5% of which will come from ships released from storage.

Crude long term intact

The IEA forecast for 2010 global crude demand is that it will increase by an anemic 1.6% or 86.3 million barrels a day from the group’s 2009 estimate.

For now, most analysts are holding the 2010 forecast between JP Morgan’s $72 to $90 by Goldman Sachs (GS), while Bank of America (BAC) expects oil to average $85/b through 2010.

Furthermore, BofA sees a growing risk of a spike above $100/b by 2011 from a combination of loose monetary policy and dollar depreciation. Tightening physical oil supply and demand fundamentals in 2010 could also prop prices.

ExxonMobil (XOM) also indicated in its latest long-term energy outlook released last month that global energy demand will be around 35% higher in 2030 than it was in 2005. The forecast suggested:

“Oil remains the largest energy source through 2030, but natural gas will move into second place ahead of coal. In 2030, these three fuels will meet approximately 80% of global energy needs.”

Longer term, consistent positive reports in the US and China will form a base for oil to appreciate. Of course, any geopolitical upset could easily send crude all the way up to the North Pole, and then all bets will be off.

Investment strategy

Contrarian and long-term – The bearish outlook for the vessel sector could be a buying opportunity for operators like Frontline Ltd. (FRO) and Nordic American Tanker (NAT) as a recovery and emerging market play.

Short term – Depending on investment horizon and portfolio composition, the other side of the contrarian/long-term vessel sector play would be to buy puts in the sector in anticipation of lower earnings this year.

Medium term: Storage operators such as Kinder Morgan Energy Partners (KMP) and NuStar Energy (NS) should stand to benefit from the expected high oil stocks through 2011.

Long term: The long-term oil market outlook would make integrated oil companies like Exxon Mobil (XOM), Chevron Corp. (CVX), and BP Plc (BP) with strong international presence and both E&P and refining/marketing operations worthy of investors’ consideration.

A combination of all or some of the aforementioned strategies could provide some interesting diversification and hedge as well.

Source: Dian Chu, Economic Forecasts & Opinions, January 17, 2010.

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