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September 23, 2009

What Does A Flattening Oil Contango Mean?

By Dian L. Chu, 09/23/2009

Starting about ten months ago, if you have access to oil storage tanks plus enough financial resources, sky was the limit to buying spot crude oil and selling a year or so forward on Nymex. For more than six months, it was a highly profitable trade when the spread between the near-month and forward contracts was about $10/bbl or more with a return of more than 15% (Fig. 1). During the super contago phase of late 2008 and early 2009, the spread was so ridiculously wide that the rate of return was close to 70% at one point of time.

Why is the Contango Flattening?

You may recall that the spread gap opened just a few weeks after Lehman Brothers (LEH) failed and AIG (AIG) required a capital infusion. Those few who had a role in taking advantage of the super contango ended up boosting the spot oil price back to a more normal relationship to the outer months. This is one of the reasons that the contango in the WTI Nymex crude market has weakened over the last few months quite substantially (Fig. 2).

In addition, the weakening contango in Nymex might also be related to an investigation by the Commodities Futures Trading Commission (CFTC) and other authorities into long-only funds and ETFs. Since much of the long-only fund buying has taken place in the futures, their liquidation in response to the regulatory investigation is likely putting downward pressure on futures contracts, narrowing the contango in WTI Nymex.

Reviewing Market Fundamentals

Spot prices becoming more expensive relative to future prices will typically encourage refiners to convert crude into product drawing down crude inventory. It will also dis-incentivize speculative crude storage hoarding, and provides incentives for producers, and OPEC in particular, to start some of the shelved projects. The same goes for non-OPEC producers. So a weakening contango, if sustained, will likely help normalize the crude supply and inventory levels.

However, the demand outlook remains dismal. The U.S. EIA just reported domestic consumption of liquid fuels and other petroleum products declined by almost 6.3% year-over-year during the first half of the year, one of the steepest declines on record. Total consumption is now projected to decrease by about 4% year-over-year in 2009 and grow only 1.4% in 2010 (Fig. 3). The latest EIA weekly petroleum report also showed the year on year U.S. gasoline inventory was 23.1% higher, while distillate fuels rose to their highest level since January 1983 (Fig. 4).

Is it Bullish?

A narrowing contango is traditionally seen as a bullish sign for the crude market, but investors interpreting the current flattening contango as such should probably beware. Based purely on market fundamentals, crude oil should be priced around $40 a barrel. At the moment, the murky economic and demand outlook is not yet supportive of the current oil price levels. The risk is likely on the down side in the near term, as any further increases in crude prices are less likely without an increase in consumption.

Goldilocks of Oil Prices

Nonetheless, once economic recovery returns, demand may jump sharply and then the existing oil reserves would come under pressure. In addition, crude prices of late have been tied to the equity markets, which have been trading irrationally on a weak dollar rally. Amid expectations of a further weakening U.S. dollar against emerging markets currencies, coupled with the current seemingly satisfactory oil price levels to both consumers and producers, crude price could well be sustained at around $60 to $75 a barrel range quite possibly through 2011 or 2012 barring any Force Majeure events.
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