Stop Counting On Oil Contangos

I feel like I’ve created a Frankenstein.

By Dan Dicker, Oil & Energy Insider:

In early 2009, I did a segment on CNBC with Erin Burnett and the late Mark Haines, pointing out a way for us to band together and make some serious money.

I proposed we find the funds (or the financing) to buy currently priced oil on the physical markets, trading somewhere in the mid 30’s, and then selling the futures about six months out, which were trading for nearly $15 dollars a barrel more.

A simple idea – we would store the oil, pay the fees, and deliver at the futures price later, banking about, I estimated, 11 dollars a barrel – a huge profit in any language.  There were problems with the plan, however; credit was, in the depths of the financial bust, nearly impossible to find, and you needed storage as well, also a really tough problem with collapsing demand and economies shutting down.

I wasn’t a genius in devising this scheme, of course. Those who had ready credit and ready storage – like Koch and Conoco-Phillips – were already doing this primitive ‘carry trade’ and making those fortunes denied to Erin, Mark, and I. However, I was, I think, the first crude observer to bring the idea of a profitable oil carry trade to the public eye.

Since then, over the course of many years, there’s been an increasing interest in the spreads between futures and what it might portend for prices and the movements of oil in storage. Today, there’s a virtual frenzy of discussion about what are almost insignificant movements in spreads, signifying apparently big moves from physical players in their commitments to prices and storage.

In this new world, a contango (like in 2009, when futures prices were higher than current ones) is bearish and indicates a strain on storage. Now, according to theory, everyone awaits a big shift towards backwardation (where prices in front of the curve are premium) to indicate an emptying of storage and prices moving higher.

I feel like I’ve created a Frankenstein.

2009, and even the far less deep contango we saw in February and March of 2016, definitely indicated a financial opportunity to hoard oil and play a carry trade – and also helped (and I say only helped) indicate a bottom in oil prices. But the overall theory that I helped spawn of spreads indicating universal trends for oil prices just isn’t true – and there’s a big, overwrought hunt for the red herring of spreads telling a bigger story than is actually there to be had, almost all of the time.

For example, oil made its biggest price moves from 2005 through 2007 to $142 dollars a barrel – with a very sharp contango throughout the curve that stubbornly refused to go into backwardation. That crude curve fooled plenty of traders into selling that rally early and often and losing fortunes of money on one of the most intense, one-sided trends the oil futures market ever saw.

During my 23 years of daily trade of the crude market, curves would move regularly from contango to backwardation, for a variety of reasons – and woe be the trader who had decided that he had found the ‘secret’ through those spreads to understanding completely and predicting, without fail, future moves in the price of oil.

All this to say that the crude curves have been historically a lousy indicator of future market action, except under the completely extreme conditions we saw during the financial crisis of 2008 and recently during the extreme oil bust of 2016.

It strikes me, instead, that this latest drop in oil prices is almost entirely due to too many longs in a market being spooked by the hand-wringing of multiple CEO’s and OPEC at CERAweek. Now, having chased out the weakest of these longs, indicates, to me, an opportunity to buy some great oil companies at discount prices.

And ignore the clomping Frankenstein of tiny spread movements that are marching with great fanfare through the public square. I built him, and you can take it from me – he’s (almost always) completely harmless. By Dan Dicker, Oil & Energy Insider

First oil & gas, then construction, then new vehicle sales. Read…  How Auto Sales Are Getting Crushed in Houston

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  18 comments for “Stop Counting On Oil Contangos

  1. Tom Welsh says:

    Surely the market guarantees that all players will follow the most profitable strategy, whoever recommends it.

    Unless the theory of the market is all wrong, which couldn’t happen.


    • Raven says:

      The ‘Market’ only has a partial effect on prices – how big the part depends on the needs of US politics at the time.

      eg Crude went to $100/bbl to get Fracking off the ground even after Global financial wipe-out & recession from the 2008 bankers crash & later dropped to $50/bbl to pressure Russia in 2014.

  2. Tom Kauser says:

    The current phrase ” third interest raise in a decade” is a clue.
    The powers that be know this is actually the third hike in short rates of the new system?
    Each time rates are pushed up it pushes more money into banks worried about derivatives going sour?
    It is very different this time except for the usual bad banking practices (Europe needs our cashflow)

  3. robt says:

    Owning and holding the physical and selling the high contango future is a no-lose situation as long as you can finance it. Somebody’s got to take it, so it’s not a spec, it’s a contract and you have the goods.
    Using backwardation and contango to ‘predict’ prices is just speculation as is any attempt to predict prices. And the COTs are still high on long specs, seemingly with a long way to drop barring any huge disruption in supply. There are probably a lot of cheater producers selling over their quota into the high prices, which could be punishing the spot. This is why OPEC is not really and not really ever was the powerhouse it’s portrayed as. They really just periodically adjust to spot.
    Turning a trade in real goods into a pure paper speculation may have unintended results, as may all leveraged financial activities based on formulaic forecasts.

  4. Lindsay Berge says:

    ‘horde oil’ seems to likely to become another of your classic typos!

  5. George McDuffee says:

    RE: For example, oil made its biggest price moves from 2005 through 2007 to $142 dollars a barrel – with a very sharp contango throughout the curve that stubbornly refused to go into backwardation.
    More evidence, if any is still required, of massive market manipulation. Far from being a disinterested regulator, the CFTC is a prime enabler by their elimination of reasonable restrictions on futures creation/trading. How can more oil than is physically available (and gold, wheat, and other commodities for that matter) be honestly traded?

  6. Duane says:

    Generals develop strategy based on past wars, same for such financial strategies.

    Contango worked in GFC cos its a short and sharp crisis. This is a slow grind to the bottom and we have yet to hit the bottom of the barrel.

    Coupled with shipping firm and owner bankruptcies, Contango is a great way to play grenade roulette.

    Unless one has good info n deep pockets.

  7. One of my fabulous readers was discussing currency worth within the context of energy, so this is appropriate here …


    “The important comparative dynamic is the worth of currency vs the worth of what currency buys. Okay, what does it buy? Does currency buy commerce or capital (non-renewable natural resources)? Currency HAS to be worth less than commerce otherwise people will hold currency and business will wither. This is what happened during the Great Depression. Money was worth more than commerce and the world’s economies devolved to arbitraging different kinds of money in order to gain gold. It reached the point were everyone was hoarding claims against gold because hoarding was more ‘productive’ than commerce, literally anything else that could be bought with the money. In a way, money/gold became a proxy for food w/ starvation as the only incentive to turn loose of currency … yes, it was that bad.

    At the same time, fuel must be worth less than commerce as well otherwise it will be hoarded. Somewhere out there in TV-land is the consumer who decides for whatever reason to become a resource hoarder. I keep hoping it’s me! That marginal hoarder is hard to find but he’s the most important character in this ongoing drama of currency worth and business ‘success’. Once he (or she) decides to make the switch the consumption regime becomes too costly to support in real (vs. abstract) terms.

    This ‘marginal man’ (or marginal woman) may have already appeared; if not, his (her) arrival is inevitable. Commerce cannibalizes itself so efforts to increase commerce are self- defeating due to resource stripping and the concomitant steady erosion of purchasing power.

    Is there going to be inflation? It would be indicated by an increase in nominal energy prices. So far every increase causes a credit ‘problem’. A price increase is the logical outcome of a shortage: a scarcity rent is added to the producer cost. Actually collecting that rent is the problem: the price remains stable- or declines instead of rising, while the customers lose the ability to meet the price. Thwarting the customers is how the scarcity rent is captured, by corralling wages and earning capacity. Customers discover their credit is inadequate or that access to credit is reduced or eliminated. Without credit the oil prices cannot rise at all, or else they rise briefly then crash. Prices have been falling in fits and starts since 2008 despite the best efforts of finance, government and central banks to prop them up … these institutions are doomed to fail as their job is to prop up the elites in finance, government and banks themselves, leaving the customers standing behind the door. They (the customers) aren’t getting richer … either in real or nominal terms, oil shortages will not improve their lot => more price deflation.”

    These guys can analyze until the cows come home … but the customers are still broke.

    • Petunia says:

      Not only are the customers broke, but they are arbitraging locations by moving to cheaper and cheaper locals. In my own case, we have made major moves more than once. Our ability to earn is capped but our ability to move out of high cost areas is incentivized.

      This is a play on the currency arbitrage of the depression you describe. Instead of currency, mobility is the substitute asset. While people keep moving out of colder, de-industrialized, high energy cost, or highly populated areas, the price of energy will keep dropping.

  8. pete says:

    Yeah Dan…and how about that Brent premium…what a joke that was, with our pipeline systems unable to adjust and our immediately-past administration so selflessly clueless. Best…PJS

  9. r cohn says:

    The real issue is not financing but finding storage at rates to make the carry trade profitable.Last winter rates for land based facilities zoomed as storage facilities became increasingly hard to find.This in turn created demand for tanker storage.
    I do not know which great oil stocks that the author was referring ,but CVX RDS among others are liquidating assets and borrowing money just to finance their dividends.And XOM has been unable to replace its reserves

  10. Sadasivan says:

    Here is the Conspiracy side of the price of crude reaching $142/bbl,levels.The USA was pressing India,on the so-called,”Indo-US Nuke Deal”,quite hard.There was to be,a discussion in the Indian Parliament,regarding the same.The ruling UPA,Coalition, had to justify ,signing the so-called “deal”,though ,this was vigorously opposed by many,both in the Ruling Coalition and the Opposition.
    The trick was to cite the HIGH Crude prices and comparatively low price of Nuclear Energy.This was the time the Crude price started rising to these levels.
    As an aside,no sooner the so-called “deal” was approved by the Indian Parliament,than Lehmann Brothers collapsed!The rest is history.

  11. RagnarD says:

    I’m not sure with what you mean by, “I was, I think, the first crude observer to bring the idea of a profitable oil carry trade to the public eye.”

    I learned about contango / storage trades in grad school in 1996, from authors / professors /traders who clearly were doing it well before then.

    As far as I understand it, if you are a futures / physical commodity trader this is one of the key aspects of what you do every day. Is today and always has been.

    Whether or not Joe Sixpack is in on it, I don’t think moves the market, because the millions and billions of the Soros / Griffin types are already shifting the waters.

  12. Ambrose Bierce says:

    In 2006 ahead of the midterms Hank Paulson, an old Goldman man, used his influence to have gasoline removed from the Goldman commodity index, the result was falling prices, just ahead of the elections, which the Dems managed to win anyway, since most of the public didn’t believe that falling gasoline prices were anything more than a political stunt. At the time I studied the problem the ruse of enterprise storage buying crude from the SPR, on paper anyway, and using that storage to bargain with Saudi tankers waiting outside NY harbor. Traders stopped paying attention to inventory reports, but you could still figure it out by watching crack spreads. The SPR was at the time expanded to count enterprise and government storage, and the DOE was authorized to release that oil, at the direction of the President. The only people getting ripped off were some Arabs, and who was going to complain about that? To understand this you need someone like Jim Rickards to explain national energy policy. I have some broad notions of what that is, but a lot of hedge funds who played the oil storage game got clocked when prices fell, which has something to do with ZIRP, isolating Vlad Putin, and the Arab Spring. It’s much easier to figure out if the Yellen fed will keep the spigot open and trade the underlying index.

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