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Oil Price Faces Another 20% Drop Due To Contango Math
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.
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got ruble puts?
This oil thing is all so goddamned corrupt. I mean... this particular commodity flows out of the ground at a relatively continuous and predictable pace. These incredible price swings are the machinations of speculators and banksters. Oh, to live in a world of honest money where these predatory creatures cannot inflict such unnatural suffering upon the unknowing and innocent populations of the earth. Educate as many people as you possibly can to the sinfulness of our existing money system... it is at the root of all of the world's problems.
my question is: is it a sound presumption to say that land based storage is cheaper than floating? With baltic dry at historical lows and a zillion ships idle at anchor, and the commercial R/E bubble not allowed to pop - it may well be cheaper to store offshore
You are an idiot and know nothing about which you speak.
Please explain, So Close.
Trolls never explain their drive by slander.
Apparently he takes a more main stream view of our economic system.
Your complaint is apparently that we cannot have stable markets where supply and demand are the guiding force when so much credit can be used to invest whimsically and manipulatively everwhelming any market with purely speculative interest and shorn of any dependency on reality or natural market forces, right? Close?
In the face of that all he can do is a drive by.
Yeah, it's so easy they're just drilling off the coast of Brazil so they can watch the butts at Carnivale; finding more oil to drill as fields run dry is anything but a continuous and predicable pace, add in transport factors, refinery variations, and there's plenty of natural supply-side volatility to be had.
The speculators and banksters don't help. but they aren't invincible either.
Fight global bankster terror: ride a bike.
Were you long /CL?
"But surely", says Ernest Moniz, "you jest! That can't be that you pay more to hold the same amount just because of time and then tell me it's all floating out there in some fucking boat! Whaddu take me for, an idiot?"
http://en.wikipedia.org/wiki/United_States_Secretary_of_Energy
Where I live gasoline and diesel are down a maximum of 10% and heating oil 15%. So much for the 60% drop in crude. It's all manipulated to fuck squared and back.
As an engineer, I have to say I find this financial wizardry to justify maintenance costs of storage in oil tankers sitting and decaying based on speculative plays is a horribly inefficient process and displays significantl tendencies of non value added activities.
If oil drops to $10 we'll have Putin right where we want him ..... facing a foe with 150 million jobless people.
>>>displays significant tendencies of non value added activities.
Since 1913 or so, most of Western Civilization as been a "non value-added activity".
Bu if you include internet porn, maybe not.
Take out an 84 month car loan and buy crude.
Hey!! Now you're talking. What could go wrong?
I nowz support obama cuz he fills my tank up cheap.
Signed, American stupid voter.
http://youtu.be/P36x8rTb3jI
Obloma voters claim they will never have to pay for gas or their mortage again, in 08'.
HOPE, HOPE AND CHANGE !!!!!!!
I think it will fall because producers will hit that one year bid, and keep hitting it.
Easy to do and $66/barrel looks awfully good in a crappy economy.
$gaso has risen 467% annualized in the past month. #WINNING
Oil may not be down for long.
Ali Younesi, the senior advisor to Iranian President Hassan Rouhani said today that: “Iran today has become an empire as it was throughout history and its capital now is BAGHDAD which is the center of our civilization and our culture and identity today as it was in the past”.
Source?
MOSSAD.
Now if we just had a Strategic reserve we could just pump it out and pump it back into the ground for when we needed it.
( i have no idea whether that is sarcasm or not )
The Chinese mastered this technique with Iron & Copper. Buy the shit out of physical(spot) expensive, and lever it 3x with bogus credit contracts, from corrupt storage facilities.
Then take the 3x credit and short the front end x3 paper market.
every day some bank comes out saying how lower the oil will go ... these are the same guys that kept saying how oil will stop going down when the price was collapsing ...
Ethanol is a problem because it is so corrosive.
Only transport by rail which is very expensive. Still cheaper than gasoline though. Probably why those trains keep exploding. "Hurry up before the price collapses again."
you're thinking of methanol
If only we could find a way to convert dry cargo ships into tankers! Plastic bladders maybe?
Crude to be exported out of the US in 3...2....1
have to get the okay from the Department of Energy first.
Unfortunately I don't think thats a part of Barry's plan to crush the US oil industry.
Zerohedge keeps beating the drum for lower oil prices and usually the source is a bank. Since when has a bank given honest or insightful council? The longer oil stays down the more powerful the next bull cycle will be. You can't print oil and if you guys believe the numbers coming out of the EIA, well good luck. I would appreciate if zerohedge would quit referring us to bank research but it shows that there are worms on every site trying to frame concensus for us. A storm is coming with a falling currency, falling oil production and falling temperatures.
Uh, oil is supposed to drop in order to make the VLCC contango storage play profitable????? What in the fuck kind of thinking is involved here? Contango exists partly due to traders buying the backs because they think prices will rise in the future. Obviously part of it is storage but mostly it's speculators. So the VLCC contango players are buying spot which should drive it up and reduce contango due to spot rising and the contango player simply locking in the positive contango. However, as these guys drive the contango to the point the VLCC trade doesn't work, it then isn't workable, no reason for oil to drop just so it could be. Now maybe the author just assumes oil will continue to be "oversupplied" and that is their basis for this argument but my bet is that we are already seeing producers being forced to cut back because they can't get their oil to market due to lack of carrying capacity. This trade itself will limit the ability of ME producers to send their oil by ship as it will reduce available shipping capacity and increase rates.
These are all the very same reasons no one wants to own gold. You have to store it out on your boat, have some one come by to check on it, someone else to polish it up every week, and insure against its loss. Contango means lower prices for oil and all the other commodities as well.