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March 9, 2015

Soc Gen: Math on Contango Trade Means Oil To Face Another 20% Drop

By Tyler Durden at ZeroHedge 
Want to know where oil prices are headed? You need to understand the economics of the floating storage play, Soc Gen says. 
As we noted on Friday, retail investors looking to be the next Jed Clampett have piled into the U.S. Oil
fund over the past several months, presumably unaware of the extreme contango in the market. That said, it’s not just retail investors who are itching to dive in. Here’s Soc Gen:
The motivation to buy it [is] widespread and not always based on traditional market analysis – consumers [are] keen to lock in lower prices with their newly expanded credit lines, due to the decline in the notional value of their existing hedges. Endowments and Sovereign Wealth Funds (SWFs) [are] under pressure to use the “opportunity” to claw back recent losses. 
For those looking to make a play near the bottom, it’s worth considering the level at which the oil storage trade becomes profitable. At its core, the trade is simple: 
A trader buys physical oil now at a low price, and simultaneously sells paper forward at a high price, thus locking in a profit margin. If this profit margin is higher than the cost of fixing a vessel to store it on, the trade works, and it should happen.
Although, as Reuters notes, “the capacity of U.S. commercial oil storage tanks has expanded by a third since 2010,” the global stock increase is set to be nearly 3 times bigger than during the last oversupply period (in the aftermath of the crisis). Given that floating storage was used in 2008-2009, it’s likely that cheaper on-land storage capacity will dwindle necessitating the use of crude carriers this time around as well. And with that, here is your step-by-step guide to the floating storage play courtesy of Soc Gen: 
1. Once on-land storage starts to fill, oil is sold at lower prices in the spot market to shed the excess production. The buyer (merchant) of the physical oil fixes a VLCC (very large crude carrier) which can hold roughly 2Mbbl, equivalent to 2000 futures contracts) time charter vessel to store the oil. The merchant buys the Brent oil (for example) in the physical market. Price as of the time of writing, $57.00/bbl for a notional value of $114,000,000 ($57.00 * 2,000,000).   
2. The merchant fixes older VLCC if possible as these are cheaper and less efficient. As the merchant is just storing the oil, efficiency is not of great concern. The most recent time charter fixture was estimated to be $43,000 a day or $17,028,000 for the time period (see table below – 396 days).    
3. At the same time the merchant locks in the forward rate of $66.61 (as of the time of writing) which equates to $133,220,000 ($66.61 * 2,000,000). This means the contango of $9.61 for the year ($0.80 cents a month) equates to $19,220,000 ($9.61 * 2,000,000) gross revenue.   
4. However, the cost of floating storage play is not just about the time charter cost. In order to lock in the contango the merchant must incur other, non-trivial storage costs. While the cost of insurance of the vessel is typically included in the time charter cost, the cargo insurance is not. We estimate that cargo insurance is approximately 1% of the value of the cargo (at current prices) or over $1,140,000 (1% * $114,000,000 million) per annum. Hull cleaning (once per month)3 , two days steaming to remove growth, idle bunkering and financing of the VLCC rates and financing costs, add up to an additional $2,121,996 per year, for a total of $3,261,996.   
5. Most VLCCs are unable or not allowed to unload (or possibly load) directly at the port, so the merchant may have to incur the costs of chartering 3 Aframax vessels to carry out the ship-to-ship (STS) operations over a 10-day period. These costs are non-trivial and we estimate that at current fixture observations, this adds up to $651,000 (see table below).   
6. In order to lock in the contango the merchant must hedge and finance the hedge position (the margin). We estimate conservatively that at $4,500 a contract margin (which we include some movement due to variation margin), the $9,000,000 margin would be financed and cost $453,500. We estimate trading fees to total $10,880.
Got that? The important point here is that Soc Gen believes finding the level where this becomes economically viable (i.e. profitable) can serve as an important guide for where crude is headed. In other words, the bank is looking for the front end of the curve to fall until the contango is wide enough to make the floating storage play enticing.  
The example Soc Gen uses shows that Brent needs to see ~$49 before the trade is sufficiently profitable.  
Interestingly, Soc Gen notes that putting this trade on has the effect of moving prices away from economically viable levels: 
With each round of floating storage, the merchant buys the spot oil, which will lend some support to the front end, and as the one-year forward contract is sold, there will be pressure on the back end of the curve - essentially reducing the contango (slightly). As more crude is being produced, and more pressure to sell the next marginal floating storage play, a lower front month price is required to make the floating storage play economically viable. The can be a drawn-out process and may take some time to finally reach this point.
The takeaway here is that storage availability and contango should be taken into account when considering the future direction (and ultimate bottom) in oil prices. Based on the above, crude could be headed much lower going forward. 
Courtesy Tyler Durden, founder of ZeorHedge (EconMatters author archive here


The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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