I came across a great line in Barron’s the other day. You know all about bull markets and bear markets... what we have now is a “Jim Morrison market.”
Why a Jim Morrison market? Because the future’s uncertain and the end is always near.
(I thought that was too good not to share. For those of you who aren’t fans of The Doors, we’ll move right along...)
Something’s Happening Here...
Something very strange is going on with the price of oil. Not just in terms of straight-up price, but in regard to the huge discrepancy between the near-month and far-month futures contracts.
As I write, the going price for near-month West Texas Intermediate crude is $36.51 per barrel. The December 2009 contract, on the other hand, is trading at $55.13.
That is a monster spread. We’re talking a difference of more than $18 a barrel between spot crude – the stuff you can buy in the cash market – and crude slated for delivery at the end of this year.
The technical name for this situation is contango. That’s what they call it when a forward-month commodity contract is trading at a higher price than the near month. (You don’t really need to know this right now, but the opposite of contango, when near-term prices are higher than the back months, is backwardation.)
Why a Jim Morrison market? Because the future’s uncertain and the end is always near.
(I thought that was too good not to share. For those of you who aren’t fans of The Doors, we’ll move right along...)
Something’s Happening Here...
Something very strange is going on with the price of oil. Not just in terms of straight-up price, but in regard to the huge discrepancy between the near-month and far-month futures contracts.
As I write, the going price for near-month West Texas Intermediate crude is $36.51 per barrel. The December 2009 contract, on the other hand, is trading at $55.13.
That is a monster spread. We’re talking a difference of more than $18 a barrel between spot crude – the stuff you can buy in the cash market – and crude slated for delivery at the end of this year.
The technical name for this situation is contango. That’s what they call it when a forward-month commodity contract is trading at a higher price than the near month. (You don’t really need to know this right now, but the opposite of contango, when near-term prices are higher than the back months, is backwardation.)
The reason this is strange is because of the massive profit opportunity embedded in the crude market.
Assuming you had the means, you could go out right now and sell millions of dollars worth of December crude contracts at $55 dollars a barrel... buy the equivalent amount in the cash market for $37 a barrel or less... and then just wait until it’s time to deliver the oil (and lock in your $18 profit).
The only hitch in the deal is finding a place to store the stuff. If you were to buy crude on the cheap now, you would have to take delivery and store it until late November (or whatever month your delivery date rolls in, when you close the trade and take your locked-in profit).
A number of big, savvy players are making exactly the trade I just described. They are selling millions of barrels worth of expensive far-month futures contracts, buying the equivalent amount of cheap oil in the cash market, and storing that oil in huge supertankers moored off the coast of Scotland and the Gulf of Mexico.
Storage and financing are counted as part of the trade, of course, and those big tankers don’t come cheap. Costs can run as high as $68,000 per day to keep one sitting idle.
But when you can lock in $18 a barrel, who cares? When the outlays are spread over millions of barrels – and a single ship can hold 2 million barrels of crude – there is still an obscene amount of profit left in the trade.
Frontline Limited (FRO:NYSE), the world’s biggest owner of supertankers according to Bloomberg, estimated last week that 80 million barrels worth of oil are being “stored” this way – the most they’ve seen in 20 years.
Not only are some big Wall Street players making this trade (Citigroup, Morgan Stanley, etc), big oil exporters are doing it too. Iran is filling up tankers with crude, no doubt waiting for the opportunity to sell at higher prices.
What It Is Ain’t Exactly Clear...
The puzzling question is why the anomaly persists. Why has the spread not come in?
Remember that once the far-month contracts are sold, price risk is removed from the equation. If you’ve entered into a deal to sell 2MM barrels of crude at $55 after buying at $37, you don’t have to worry about where prices go between now and your delivery date. You can just sit and wait.
When a no-brainer opportunity like this comes along, Wall Street normally jumps all over it. Traders exploit the anomaly in size until it disappears.
If markets weren’t so out of whack, you would gradually see the spread between near-month and far-month crude contracts get smaller and smaller as more and more players piled in. The profit in the spread would be reduced to the point where putting on the trade no longer made sense.
Two constraints that keep this from happening now are financing and storage.
First the finance angle: This is a trade that requires a serious cash outlay (or a major line of credit) to pull off. To fill up a supertanker with crude and sit on it for a year, you’re talking $50 million to $100 million as table stakes. The big Wall Street houses have been so bruised and battered, it’s hard for them to come up with that kind of dough – even for slam-dunk opportunities.
The other major constraint to the trade is storage. Such huge volumes of cash market crude are being held off the market now, traders are literally running out of places to put it. (It’s not like you can just pop into the local EZ-storage or stash a million barrels of oil in the shed.)
Curiouser and Curiouser
The storage issue is also creating headaches for the New York Mercantile Exchange (NYMEX) as traders question the pricing of West Texas Intermediate (WTI crude). The Financial Times reports:
The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America’s pipeline system, has depressed its value not only against other global benchmarks, such as Brent, but also against other domestic US crudes.
Julius Walker, an oil market analyst at the International Energy Agency in Paris, said there was “anecdotal evidence” of traders moving away from WTI and “doing deals based on other US oil benchmarks.”
In other words, we’ve got oil coming out of our ears in the short-term... but the price of oil is still head-scratchingly higher – much, much higher – in the longer term.
So what does all this mean for us small-fry traders, i.e., those of us who can’t dial 1-800-TANKERS-R-US like the big boys?
I can think of at least a few takeaways worthy of food for thought:
~Why aren’t the big oil exporters all over this trade? Iran has locked up a few tankers, and it’s likely Russia and Venezuela etc. have too. But these guys are supposed to have lots of oil in the ground... and OPEC just made a big fuss of capacity cuts... so why aren’t they selling the hell out of the far-month crude contracts, locking in $18 a barrel, and bringing the spread back in with their size? Could it be capacity constraint? Could it be these guys don’t actually have all the spare capacity they’re letting on?
~Why are the drillers and oil service names so depressed? Stock markets are supposed to discount the future, not the past. Equity valuations are supposed to be forward looking. And yet, at current multiples, most of the high-quality drillers and oil service names are trading as if oil were headed to $20, not back to $60. Yet the December crude contract says otherwise... and the huge spread between near-month and far-month contracts persists. What gives?
~Could Wall Street still be “broken” in the aftermath of 2008? After the year we just went through, anyone who still believes in perfectly efficient markets should have their head examined. Markets operate in a range from “mostly efficient” to “wildly, insanely INefficient.” When credit mechanisms and normal channels break down, things just stop making sense. Could the huge disconnect between forward-month oil contracts and insanely cheap oil service names be yet another example of Wall Street not making sense?
~Could December crude contracts be expressing an opinion on the inflationary effects of U.S. debt monetization... or rebound possibilities for emerging markets... or both? It’s widely recognized that the U.S. Fed and Treasury are embarking on a “great experiment” now that has never before been tried – one that could be summed up as, “Print like crazy and see what happens.” Some observers, like Joachim Fels of Morgan Stanley’s Global Economics Team, further believe that emerging markets could outperform in 2009 due to better internals than they get credit for. Could the persistent crude spread be reflecting both views?
Yep, no question... something’s happening here.
Assuming you had the means, you could go out right now and sell millions of dollars worth of December crude contracts at $55 dollars a barrel... buy the equivalent amount in the cash market for $37 a barrel or less... and then just wait until it’s time to deliver the oil (and lock in your $18 profit).
The only hitch in the deal is finding a place to store the stuff. If you were to buy crude on the cheap now, you would have to take delivery and store it until late November (or whatever month your delivery date rolls in, when you close the trade and take your locked-in profit).
A number of big, savvy players are making exactly the trade I just described. They are selling millions of barrels worth of expensive far-month futures contracts, buying the equivalent amount of cheap oil in the cash market, and storing that oil in huge supertankers moored off the coast of Scotland and the Gulf of Mexico.
Storage and financing are counted as part of the trade, of course, and those big tankers don’t come cheap. Costs can run as high as $68,000 per day to keep one sitting idle.
But when you can lock in $18 a barrel, who cares? When the outlays are spread over millions of barrels – and a single ship can hold 2 million barrels of crude – there is still an obscene amount of profit left in the trade.
Frontline Limited (FRO:NYSE), the world’s biggest owner of supertankers according to Bloomberg, estimated last week that 80 million barrels worth of oil are being “stored” this way – the most they’ve seen in 20 years.
Not only are some big Wall Street players making this trade (Citigroup, Morgan Stanley, etc), big oil exporters are doing it too. Iran is filling up tankers with crude, no doubt waiting for the opportunity to sell at higher prices.
What It Is Ain’t Exactly Clear...
The puzzling question is why the anomaly persists. Why has the spread not come in?
Remember that once the far-month contracts are sold, price risk is removed from the equation. If you’ve entered into a deal to sell 2MM barrels of crude at $55 after buying at $37, you don’t have to worry about where prices go between now and your delivery date. You can just sit and wait.
When a no-brainer opportunity like this comes along, Wall Street normally jumps all over it. Traders exploit the anomaly in size until it disappears.
If markets weren’t so out of whack, you would gradually see the spread between near-month and far-month crude contracts get smaller and smaller as more and more players piled in. The profit in the spread would be reduced to the point where putting on the trade no longer made sense.
Two constraints that keep this from happening now are financing and storage.
First the finance angle: This is a trade that requires a serious cash outlay (or a major line of credit) to pull off. To fill up a supertanker with crude and sit on it for a year, you’re talking $50 million to $100 million as table stakes. The big Wall Street houses have been so bruised and battered, it’s hard for them to come up with that kind of dough – even for slam-dunk opportunities.
The other major constraint to the trade is storage. Such huge volumes of cash market crude are being held off the market now, traders are literally running out of places to put it. (It’s not like you can just pop into the local EZ-storage or stash a million barrels of oil in the shed.)
Curiouser and Curiouser
The storage issue is also creating headaches for the New York Mercantile Exchange (NYMEX) as traders question the pricing of West Texas Intermediate (WTI crude). The Financial Times reports:
The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America’s pipeline system, has depressed its value not only against other global benchmarks, such as Brent, but also against other domestic US crudes.
Julius Walker, an oil market analyst at the International Energy Agency in Paris, said there was “anecdotal evidence” of traders moving away from WTI and “doing deals based on other US oil benchmarks.”
In other words, we’ve got oil coming out of our ears in the short-term... but the price of oil is still head-scratchingly higher – much, much higher – in the longer term.
So what does all this mean for us small-fry traders, i.e., those of us who can’t dial 1-800-TANKERS-R-US like the big boys?
I can think of at least a few takeaways worthy of food for thought:
~Why aren’t the big oil exporters all over this trade? Iran has locked up a few tankers, and it’s likely Russia and Venezuela etc. have too. But these guys are supposed to have lots of oil in the ground... and OPEC just made a big fuss of capacity cuts... so why aren’t they selling the hell out of the far-month crude contracts, locking in $18 a barrel, and bringing the spread back in with their size? Could it be capacity constraint? Could it be these guys don’t actually have all the spare capacity they’re letting on?
~Why are the drillers and oil service names so depressed? Stock markets are supposed to discount the future, not the past. Equity valuations are supposed to be forward looking. And yet, at current multiples, most of the high-quality drillers and oil service names are trading as if oil were headed to $20, not back to $60. Yet the December crude contract says otherwise... and the huge spread between near-month and far-month contracts persists. What gives?
~Could Wall Street still be “broken” in the aftermath of 2008? After the year we just went through, anyone who still believes in perfectly efficient markets should have their head examined. Markets operate in a range from “mostly efficient” to “wildly, insanely INefficient.” When credit mechanisms and normal channels break down, things just stop making sense. Could the huge disconnect between forward-month oil contracts and insanely cheap oil service names be yet another example of Wall Street not making sense?
~Could December crude contracts be expressing an opinion on the inflationary effects of U.S. debt monetization... or rebound possibilities for emerging markets... or both? It’s widely recognized that the U.S. Fed and Treasury are embarking on a “great experiment” now that has never before been tried – one that could be summed up as, “Print like crazy and see what happens.” Some observers, like Joachim Fels of Morgan Stanley’s Global Economics Team, further believe that emerging markets could outperform in 2009 due to better internals than they get credit for. Could the persistent crude spread be reflecting both views?
Yep, no question... something’s happening here.
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