Oil Price Fundamentals: Ignore the Hype

Last week, Marketplace had an interesting report on the growing trend of “contango” in the oil industry. For those of you who are not familiar with the practice, contango occurs when investors sit on a commodity because the future price is higher than the spot price. In this case, that results in full oil tankers sitting offshore, waiting for the price to rise before they unload their 50 million barrels onto the market. So a quick buck is made by those holding the inventory on the high seas, but what happens when those barrels eventually reach a port ? We’ve got a glut of material again, which forces prices down. This type of profit-taking merely adds to the volatility of the market, but has little influence on macroeconomic fundamentals.

Frankly, it seems as though the oil/energy sector has the most interesting bag of tricks when it comes to speculation, rhetoric, and other market manipulation. But all the headline grabbing stories aside, oil is just like other commodities in that pricing is governed by supply and demand. While contango, Somali pirates, and accounting tricks can be a source of market volatility, these games don’t have a long term impact on pricing.

In my opinion, what is far more interesting is how OPEC production cuts and the current Middle East turmoil suddenly don’t seem to impact oil prices. Despite Saudi Arabia’s announcement of further production cuts on Monday, the price of oil continued to fall. And as the Wall Street Journal reported, many analysts also see a decoupling of oil prices from the value of the USD. These are major departures from historic influences on oil prices, and they really drive home how sluggish demand is right now.

Comments

[Urbane Gori...:]

I think a little clarification is in order. Contango just means that the futures prices for oil (in this case) are higher the farther out you go. In other words, March futures cost more than February futures. Backwardization is the reverse.

Coincidentally, the cost to rent a tanker is cheap right now and there are spare ships available that can be used as storage. The day rate is about 8% of what it would have cost to store oil last year and as there is a reduction in demand for oil, there are a lot of spare tankers idling away.

Your statement "contango occurs when investors sit on a commodity " is not really correct. Contango occus when buyers are willing to pay more for a further out contract. The availability of spare tankers which can be used for storage is coincidental to our world recession.

Needless to say, this will make some oil producers happy (Shell has been reported as jibbering with elation and they are taking full advantage of the situation. Sau\di Arabia has also been noted as having oil laden tankers in various ports... They'd probably be happier selling right now.)

At any rate. Contango and Backwardization are just state of the futures contracts and the sipping/storage issue is coincidental.

jegan

Jan 15 01:24 AM

[Swami:]

Is there any way for a retail investor to play the Oil Contango ?

Jan 15 01:43 AM

[donzelion:]

Swami - a retail "investor" could play contango using DIG and DUG - but unless you know more about shipping than the oil traders and shippers, such trades are merely gambles. You'd probably do better just playing blackjack.

Normally, its the "perception" of supply and demand that dictates price in commodity/futures markets, not the actual supply and demand (otherwise, there'd be no futures market, and only the spot market). Since accounting gimmicks influence perceptions, they can indeed have a "long-term" effect on pricing (if "long" is measured in years rather than centuries).

Jan 15 04:04 AM