Oil Guesses Are Wrong Again, Contango Grows

By Brad Zigler

Real-time Inflation Indicator (per annum): 7.9%

According to the U.S. Energy Department's weekly inventory report, domestic crude oil supplies increased 7.3 million barrels last week, far exceeding the forecast for a 900,000-barrel build made by Oil Patch analysts. Traders opened the NYMEX futures floor session 3.4% higher ahead of the report, following a 6.7% decline on Tuesday. The United States Oil Fund (AMEX: USO), an exchange-traded portfolio that tracks oil futures, fell $2.77 in lockstep to finish at $41.36.

The inventory spike marks the tenth consecutive weekly increase. Domestic crude oil stocks are now in the upper half of their average range for this time of year, according to the Energy Department.

Technically, the crude market is oversold, which hints of a possible short-covering rally, but upside resistance for the nearby NYMEX futures remains firmly entrenched at $59. Until futures can close above that level, the bears control oil’s pricing. The near-term downside objective is $46.

Oil patch prognosticators also called for refinery utilization to tick up 0.2% to 85.1%, but missed their target by a wide margin. Refineries instead operated at 86.2% of their capacity, increasing gasoline and distillate fuel production significantly.

The United States Gasoline Fund (AMEX: UGA) dropped $1 to $22.31 Tuesday, tracking the 4.6% decline in unleaded RBOB gasoline. Futures, however, opened 3.4% higher in New York ahead of the government’s inventory report. Insiders called for a 100,000-barrel build in gasoline stocks to augment the 539,000-barrel increase reported the previous week. Total motor gasoline inventories, however, increased by 1.9 million barrels, reflecting a 2.8% decrease in demand from year-ago levels.

Heating oil futures began the NYMEX floor session up 3.5% today. Forecasts of an 800,000-barrel decline in distillate stocks, including heating oil and diesel fuel, buoyed the market after heating oil futures closed off 4.6% Tuesday. The United States Heating Oil Fund (AMEX: UHN) sympathetically eased 60 cents to finish at $27.31.

Energy Department tallies, however, showed distillate fuel inventories slipping by only 200,000 barrels last week. Distillate fuel demand was clocked 2.2% lower than this time last year.

Yesterday’s large dip in crude feedstock prices had the salutary effect of improving refining margins. The nearby crack spread rose to $5.71 a barrel Tuesday, yielding an 11.2% margin. A week before, margins were only 5.9%. An explanation of the crack spread significance can be found in “Time For Crack Spreads.”

NYMEX Crack Spread-Derived Refining Margins



The build in petroleum complex inventories is being reflected in the relentless widening of the NYMEX crude oil contango. Contango prevails when future prices are higher than near-month prices. The reverse, known as backwardation—where nearby deliveries are priced higher than deferred futures—is more typical of a supply-compromised crude oil market.

The quarterly contango grew to $3.56 a barrel, or 6%, Tuesday, its widest level since the market slipped out of backwardation in June. Contango creates an incentive for producers and refiners to buy oil for near-term delivery and store it in inventory. As storage fills up, storage costs rise and the contango tends to widen, providing an investment return.

Crude Oil Contango/Backwardation Vs. Inventories



Many market observers warn that aggressive widening of the contango portends a sell-off. That’s ultimately true, but it can take a while.

A lesson can be learned from the past. The last time a contango was associated with a decline in oil prices was a decade ago. Back in 1998, the oil market was trapped in a cycle which constantly reinforced contango. Rising inventories were interpreted by market participants as oversupply which depressed spot prices, further widening the differential between future and nearby deliveries. That encouraged further inventory building and still more widening of the contango. Ultimately, the quarterly contango topped out above 19%. It took large production cuts by Venezuela, Mexico and Saudi Arabia to reign in the market.

In part, the volatility in the 1998 market was a pendulum swing from the drastic backwardation seen in two years before. Our current market’s antecedent backwardation pales in comparison. The current contango, too, is relatively modest so far. The current interest rate environment, however, makes 6% a mighty attractive quarterly return.

Comments

[Greg Pinelli:]

It's time to come back to some basics..instead of the convoluted reasoning that's infected markets for so long. Contango is a normal condition. Distant prices exceed current spot. This may, of course, if the amount is great enough, cause hoarding..buy now..avoid the pain later. What we are seeing, however, are investors doing the math and looking at what is inevitable in the oil/gas market. Less drilling..less product..IEA report=Terrible news...price 6 months from now will be higher.
A very smart assumption. Enjoy your $2 gas..it will NEVER last.

2008 Nov 26 09:08 PM

[User 305589:]

it has always escaped me why anyone would pay attention to weekly oil supply numbers (except very short-term traders). these numbers will never tell you where oil is headed longer term, what furture supply-demand dynamics will be and what prices and profits oil companies will realize over time. It#s, for 99.9% of the time total noise that one can and shold totally ignore.

2008 Nov 27 04:56 AM

[mangolfer:]

The consumer has been spooked. Demand continues to drop. Price of oil cannot find bottom until demand levels out. What is so complicated here? Are you saying the drop in oil price is trying to jump ahead to level out demand?

2008 Nov 27 08:20 AM

[Tim Plaehn:]

Do you have a link for the IEA report?

2008 Nov 27 08:23 AM

[Ferdinand E...:]

Hmm. Georealist and User have some important comments, even if I have a problem accepting that contango is "normal" for the oil market. More important though, this article is valuable from a pedagogical point of view.

2008 Nov 27 08:56 AM

[toobad41:]

When oil or natural gas prices are high you can expect production overshoot down the road. That is exactly what has happened today. The opposite is true when the product prices are low (as they are now). The oil will stay in the ground until prices go back up. Why should I sell my crude at $55 a barrel when I can sell at a later date for $100 or more? Yes, I can make money at $55. It cost about $10 or $12 a barrel to get it out of the ground. Don't forget you have to pay for overhead such as drilling equipment, transportation costs, tank batteries, pump jacks, salaries, taxes, bonus money,rent, etc. It will take about 2 1/2 years to payout the cost of drilling a million dollar well. You either have to have higher product pricing or a very good producing well to justify drilling. The jest of what I say is that down the road you will see higher product pricing. That may come sooner than you think.

2008 Nov 27 09:59 AM

[Kunst:]

to reign in the market. -- rein

The jest of what I say -- jist

2008 Nov 27 04:12 PM

[Mastery:]

I suspect the contango is largely artificially created by Mexico's trades with Goldman and Barclays through which Mexico is reported to have hedged its entire 2009 production. See www.emii.com/articlepr...
Obviously massive put option hedges created sales at the front end of the curve during August September and October which have pushed this sharply down against the massive purchases at the back end. In turn this has created profitable cash and carry opportunity which have resulted in higher inventory numbers as storage is brought to capacity. This also appears to have walloped gasoline prices and for the first time in over 20 years gasoline has been consistently for more than 30 days trading below crude. Watch this space though next summer by which time much of the trade must unwind as Mexico's Puts start being exercised. It seems pretty criminal to me that Goldman is spending its new found Paulson TARP capital guaranteeing Mexico's Oil price at $90 a barrel, entering huge put option purchases with Buffet on European stocks, investing in a leveraged buyout fund as well as in its 2008 bonus pool.

2008 Nov 27 09:24 PM

[Steven Ward:]

Largeblock traders are placing huge bets the surrent situation is headed for the trash heap of history and very soon.
They went long and heavily, Chevron, Exxon, Devon, Anadarko to name a few.

2008 Nov 28 07:54 AM

[NOWHEREMAN:]

Gold has been in Contango since the abolishment of the Gold Standard. Why isn't Gold affected the same way oil is supposed to be?

Gas is on its way to $1.50, enjoy it for a few months maybe more. Since NEVER is such a long time, I have to agree with Georealist, that eventually gas will rise above $2.00 but probably not until the resumption of the seasonal driving period. And most certainly not in the face of the massive rise in unemployment.

IMHO

2008 Dec 07 02:09 PM

[Terry Thprsen:]

The Mexican hedge unnerves me. At current prices someone is on the hook for about $19b. Assuming Goldman and Barclay have hedged out their risk then this looks like another potential unwind: CDS dominoes part 2. I guess if oil gets back in the $65+ range then it's no longer a lot of money, but what if it drops all the way back to $20? That's a tasty short squeeze that a few sovereigns are in a position to effect.

2008 Dec 12 01:43 PM