Oil Market Outlook: When Contango Trade Unwinds

asiablues's picture

By Economic Forecasts & Opinions

The West Texas Intermediate (WTI) crude oil market went into contango back in June 2008 and reached an apex super contango 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 U.S. 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 U.S. Inventory

In its most recent weekly assessment, U.S. 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 U.S. in recent weeks (Fig. 2).

At 331.0 million barrels, U.S. 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 amongst the largest weekly aggregate increase ever.
In addition, FT.com reported that the U.S. strategic petroleum reserve is now full as of Dec. 27, 2009 adding to the already bearish tone in the market.
Costs & 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 forward price curve.

Discretionary stock building occurs “disproportionately” in the U.S. 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.

Storage costs money, but how much? The U.S. EIA estimated holding crude oil would cost a company about $1.50 and $4.00 per barrel per year depending if it owns or rents storage. For gasoline, the costs would be $2 and $6 per barrel per year, or $0.01 per gallon per month:
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 transporting 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 U.S. 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 & 127 Million Barrels at Sea

By one estimate, the crude 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 buy up spot and nearby futures which inadvertently narrows the spread (Fig. 3). (Read more on what a flatting oil contango means here.)

The spread between the first and sixth Brent crude-oil contracts on ICE Futures has declined 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 at least some offloading from tank farms as well.

This is when some analysts predicted that 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-mnth high of above $83 per barrel from freezing temperatures across Europe and the U.S., 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 in as far reaching as the price of oil.

Crude was weighed down by forecasts for weak demand by the International Energy Agency (IEA) and some disappointing U.S. 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 set 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 point 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.

There are other factors also underpinning the contango trade:

  • The Federal Reserve will likely keep interest rates low, curbing financing costs for those storing cargoes.  
  • The much worried 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 tend 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/gasoil 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/gasoil 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 even have 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 pushing 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 that 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 estimated to expand about 12% next year, of which 5% will come from ships released from storage.

Crude Long Term Intact

The IEA forecast for 2010 global crude demand to increase 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 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 ~80% of global energy needs.”

Longer term, consistent positive reports in the U.S. 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, then all bets will be off.

Investment Strategy

Contrarian & Long-term – The bearish outlook for the vessel sector could be a buying opportunity of 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.

Economic Forecasts & Opinions

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Richard Whitney's picture

Saddam was an excellent trader. He knew when to go long, rattle his saber for some premium, then sell.

He was just bad at bluffing, and he suffered a terminal drawdown.

Anonymous's picture

A 1.5 day supply "glut" offshore you say? Golly! We might even have an entire month or two "glut" onshore then! Only the economic alchemists weave dodgy loans into AAA rated securites and keep trying to solve runaway over indebtedness with more borrowing would be so silly as to see a glut of oil supply.

I would love to see another panic low in commodites, it will likely be the last one.

A Man without Qualities's picture

The recent economic chaos has permanently changed people's confidence in money, as can be seen from the explosion in holdings of gold via ETFs.  There are plenty who believe that oil is a far better store of "economic" value than gold, thus changing the dynamic of oil forever.  Really, there is a growing desire and need to hold oil as an asset.  

The interesting angle is the way we interpret and visualize this "physical investment oil".  

A 26 mile stretch of tankers, from Dover to Calais - wow sounds huge.

3 days consumption for the EU - that's not much.

 

127 million barrels works out at about $10 billion worth of oil stored at sea, the idea that there will be a massive unwinding of this to give $10 oil and thereby make 95% of the oil industry unprofitable seems unlikely, to put it mildly.

However, the role of oil and other commodities is changing.  I do not see the appetite for being long physical oil changing any time soon (especially given the contango and bid offer costs of investing via futures contracts) and it may well do more good in preventing spot volatility, which can only be positive for the economy.

 

trav7777's picture

This is 3 days of supply for the EU...that's a blip.

This tanker fleet and the notion that oil is overpriced is asinine.

Oil is now in supply decline, having peaked in 2008.  People don't want to admit Peak, despite that wells peak, fields peak, nations peak...but somehow the earth WON'T peak.  56/65 oil producing nations have passed peak, but the globe won't.  Right!

If you want evidence of peak oil, look at the C&C figures.  They peaked in 2005 and have declined since.  That is a reliable metric on "conventional" oil, not biofuels made from natural gas or some other form of energy.

At or past an oil peak, there is no high price that "doesn't" make sense because the freaking commodity is going into DECLINE.

Consumption has declined but so has supply.  Therefore, the price should remain permanently high.

People don't want to hear this, but the oil peak is what caused the financial creditponzi to inflect.  It heralded the END of a multicentury age of growth.

The unavailability of oil relative to the gluts of the past is going to strangle all economic activity moving up from the most marginally economical.  It simply costs *more* as a matter of energy input to do things.  A greater share of what would have been profits now gets eaten up by cost of energy input, both via declining EROI and nominal cost

spanish inquisition's picture

Nice work. The money has been spent and the oil needs to be produced at levels to service the debt that the oil producing countries have taken on. The line of tankers will grow longer as the great recession grows longer due to lower usage (or lower growth in usage) to match the OPEC economic models. The GS and JPM trading bots will work to keep prices up to keep oil producing nations out of Greece and Iceland status for as long as possible. Until the next oil crisis can be manufactured.

Anonymous's picture

I find amazing that 26 miles of tanker can only supply Europe of 3 days.

Anonymous's picture

AND/OR

Oil supply is peaking (at around 86-90 mbpd) meaning we only need enough tankers for replacement of the current fleet.

US/Europe/Japan demand has likely peaked for good. New demand will come from elsewhere.

China is still filling its strategic reserves (when the price is right - making a nice floor).

5% annual global depletion keeps cutting supply. Any drop in price hurts investment setting up higher prices to come

trav7777's picture

anyone analyzing crude contango needs to discuss peak.

Nobody yet knows what supply declines may lurk out there.  Cantarell was a HUGE shock for everybody in the world oil community - NOBODY foresaw a 34% YoY decline in production from a field like that.

Now, you have maturity starting to develop in the analyses of time-to-peak versus decline rate YoY after peak versus field discovery year and field type and that is why there is contango.

Oil supply is subject to surprises to the downside.  If that occurs, you have to have inventory.  This is why there has been an inventory build in spite of a recession.  If Ghawar or Burgan were to drop like Cantarell, we are quite rightly in deep fucking trouble and these tankers represent that acknowledgement by analysts apparently smarter than the web posters that this is the tail risk

Steak's picture

Ghawar is one of my favorite words to say ever.  Yes if Ghawar were to see Cantarell like declines it would pucker every oilman's butthole.  But thats precisely because if the Saudis can fuck up their national treasure like that then no oil engineering team on earth could be trusted to keep a field viable after peak production.  In this case I really do give the Saudis credit cause the way they've managed and developed their fields should be a model to all oil-producing countries.

gookempucky's picture

Always enjoy your comments  steak

Peak oil --bet your bippy--keep in mind that the saudis managed to spin the situation and deserve no credit whatsoever- Having been in saudi during the early 90's used to go to bahrain for beers and the stories of the massive salt water injection projects in place and running would blow your mind--the joke was that half of the country would float off into the red sea and the other into the persian gulf because they were pumping so much salt water underground. Here is a real bomb- once well head was set it only cost .18 (yes cents) a barrel to get it to well- headed downstream- Theres more to the story that is not being told.

Anonymous's picture

Very true, but as long as games can be played, GS says it will be 60-85$. This makes sense: the upper limit of 85$ is, as many annalists concur, when prices start to really hurt the so called "recovery". They try not to stay to long close to it.That is what you see now. On the downside, 60$ is an absolute minimum for reinvestments in maintenance of fields and new envelopments to happen. So GS price fixing makes perfect sens.
Now, of course, the devil is in the (technical) details. Maturing fields in the second or even third stage of development can indeed collapse suddenly. Happened before (Cantarell, Texas, North Sea, etz)and Yes, 3-5% on the downside are possible anytime this year, maybe even 10%. And then all hell breaks loose...

Anonymous's picture

Master Proxy GS has given us a cue-sheet last week, oil price range fixed at 60-85$. That's what it's gonna be, forbidding a black swan event. (Which there are a couple possible) If they say so, say will try to do God's work. Again.

DurangoKWest's picture

This is such a waste of energy.  This activity is a strobelight bringing attention to the lack of purpose in modern society. 

Anonymous's picture

It seems that Chavez is loosing control. Would political trouble in Venezuela trigger higher oil prices?

Also, why would JPMorgan Chase & Co. seek vessels for storage and their analyst maintained $72 target price?

Any comments?

gookempucky's picture

Again we are using the paper market to convey(SPIN) a situation--Bursting U.S. Inventory

In its most recent weekly assessment, U.S. 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 U.S. in recent weeks (Fig. 2).

At 331.0 million barrels, U.S. 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 amongst the largest weekly aggregate increase ever.
In addition, FT.com reported that the U.S. strategic petroleum reserve is now full as of Dec. 27, 2009 adding to the already bearish tone in the market.
331mb is moot---This country would consume that in 15 days=pronto SPR=? what do we know about the SPR and to my recollection when did the FT have access to the SPR dipstick ?--my point being is that nobody can measure the underground storage period--benefit of the doubt and SPR has 750mb-that only gives this country 34 days of supply--as for the amount of tanker volume parked-it will stay parked and loaded as the only real EMERGENCY safe storage available off country . Real data is needed to support the Bursting Inventory-try the ISL. This is how oil should trade: B=42 gallons-I'll give it all to them-One Billion Barrels supply=28 billion gals. 42 gallons cracked makes 18 gal gas-10 gal diesel-does not include jet fuel or military use of which the US Navy is the worlds largest user of diesel fuel. Gas usage=380 mgpd Diesel usage=112 mgpd We have 56 days of fuel--without military usage--this is reality-this is what the oil price should reflect. People need to quit thinking with their dipstick jimmy.
Anonymous's picture

Thank you for putting this amount in real perspective;

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

Let's say it's 4 days, and I'll still say it's insignificant blib. (almost 1 day of global consumption?)

Steak's picture

I'd say not very significant, but yeah, totally feel ya.  Global strategic reserves are 4.1 billion barrels and growing.  Global daily usage is 85 million barrels.  And if so many ships are coming online this year then there will be more floating storage space available.  

All those points together tell me we're not likely to see a major disruption from offloading sea-based storage.  Either way every big money player out there (and lotsa smaller ones) believe $100 oil again is a foregone conclusion.  In that environment I really can't imagine forced unwinds of crude holdings that are necessary to get us w/in the $30 range.

http://en.wikipedia.org/wiki/Global_strategic_petroleum_reserves

Anonymous's picture

So let me get this straight. Average worldwide consumption of oil is 84 million barrels a day (en.wikipedia.org/wiki/Petroleum), and the release of just under half a day's supply, over a period of six months, is going to be a significant factor in driving down the price of oil by approximately 7/8th?

Oil may indeed go down as low as $10 under the "right" economic conditions, but I highly doubt a single half-day's oversupply is going to be a major contributor to that in any event.

Anonymous's picture

So let me get this straight. Average worldwide consumption of oil is 84 million barrels a day (en.wikipedia.org/wiki/Petroleum), and the release of just under half a day's supply, over a period of six months, is going to be a significant factor in driving down the price of oil by approximately 7/8th?

Oil may indeed go down as low as $10 under the "right" economic conditions, but I highly doubt a single half-day's oversupply is going to be a major contributor to that in any event.

Anonymous's picture

So let me get this straight. Average worldwide consumption of oil is 84 million barrels a day (en.wikipedia.org/wiki/Petroleum), and the release of just under half a day's supply, over a period of six months, is going to be a significant factor in driving down the price of oil by approximately 7/8th?

Oil may indeed go down as low as $10 under the "right" economic conditions, but I highly doubt a single half-day's oversupply is going to be a major contributor to that in any event.

Anonymous's picture

my position
short oil ery
short bazil bzq
looking to short mexico when it start to roll-over
PS
MS BAC and GS better say oil from 75-100,They got to sell all that oil to someone(there hoping Iran gets bombs)

I hope they chock on there oil

rapier's picture

One has to assume a persistent bid is being put under futures by the Saudis and the Emerates. Then there is the Iran nuclear threat story. A staple since 1992 to excite worry and encourage longs. Then too there is the anything but cash or zero interest rate idea. Hell, just as well own oil.

 

One cannot say there will not be another oil price plunge but if it does it will be an accident.

Anonymous's picture

where's a Somalia pirate
when you need one

Grand Supercycle's picture

 

Crude daily chart has been in a downtrend for few days now.

Weekly remains bullish - for now.

 

UPDATES:
http://www.zerohedge.com/forum/market-outlook-0

In early 2007 I warned of an impending stockmarket crash.

I confirmed a bottom by early April 2009.

In mid 2009 I warned of an impending USD rally.

The uptrend since March 2009 has been a bear market rally contained within a much larger bear cycle that started in 2000.

RobotTrader's picture

Tanker stocks have been decimated the last two years.

Watch these for clues.

Price action has been positive the last two weeks.

Must be some geo-political event brewing that is going to disrupt oil supply somewhere.

 

El Hosel's picture

Oil refiners look about the same, they are beat down but they appear to be  building a nice base .... VLO,FTO,TSO,WNR,ALJ

http://stockcharts.com/h-sc/ui?s=fto&p=W&yr=3&mn=0&dy=0&id=p52317523506

http://stockcharts.com/h-sc/ui?s=tso&p=W&yr=3&mn=0&dy=0&id=p52317523506

bugs_'s picture

It is also worth noting that prior to Saddam

invading Kuwait and Desert Shield we also

saw boatloads (literally) of oil stored in

tankers.

Chopshop's picture

Operation Desert Storm began on this date (January 17th) in 1991

Ben Franklin, Al Capone & Muhammad Ali were each born 'today'

Jan 17, 1893 saw Queen Liliuokalani deposed (say that 5x, fast)

1.17.1935 - FDR delivered to Congress a report detailing the "problem of economic insecurity"

The UN Security Council met for the first time at Church House, Dean's Yard in 1946

1961 ~ Ike's Farewell Address warned against the rise of the Military-Industrial Complex

Bobby Fischer passed away on it in 2008

And last year, as Israel declared a unilateral cease-fire of its 22-day push into Gaza, Lady GaGa's 'Just Dance' topped the Billboard charts ~ exactly 34 trading days prior to the official INX bottom of March 9th ~ as everyone just wanted to hear someone, anyone, tell them that it's "gonna be ok"

All in all, Jan 17 is an interesting day in history; not a great one but definitely in the top third of calendar days as per interesting history.

an excellent WTIC / brent overview, asiablues.  thank you for it.  personally, think oil be done and while I am in the camp of sub $30, am not convinced that Prechter's call for sub $10 will be borne true by the hard right edge.