Seven Ways to Play Both Oil Scenarios

by Matt Weinschenk

A different buy-and-hold strategy has become the #1 profit-maker for 2009. And I’m not talking about stocks. Direct investments in oil, right now, are paying off in spades. And it’s because oil markets are… well, totally screwed up.

Right now, you can buy oil for $36 a barrel. And you can lock in a contract to trade oil in June for $51.30. When futures prices are higher than current prices, it’s a situation called “contango.” Oil markets expect a little bit of contango, but the spreads we’re seeing today are off the charts.

Of course, any time there is a market anomaly this severe, there’s got to be a way to profit.

The Forbidden Contango

The reason such a large contango is rare is because it’s too easy to profit from it. If you were so inclined, you could right now buy the actual physical oil for $36 a barrel, keep it for six months and have a locked in price of $51 in June. Traders do this all the time. All of that buying and selling generally brings market prices to levels where there isn’t such a large profit to be made.

So where is the breakdown in today’s market? Storage capacity has run out. Oil tanks are filled to the brim. Instead of traditional on-shore tanks, investors have taken to borrowing tanker ships, filling them up, and letting them float offshore.

(Doesn’t sound like that could be profitable? Let’s say you could get your hands on a Suez-max tanker. They run about $46,000 per day for rental and max out at 1 million barrels. With current spreads, that’s $15 million for an outlay of $8,280,000. Easy money!)

When there’s money like this being made, we’d like to earn our share. I’ve looked into building some storage tanks in my backyard. But I’ve decided I’m not that handy. So we’ll have to figure out exactly what is happening to find a chance to profit.

Where Has This Anomaly Come From?

Right now, world production for oil is about 73.8 million barrels per day (mbd). But apparently we’re not using quite that much and we don’t have anywhere to store the remainder. That is part of the reason that prices have cratered.

Traditionally, OPEC would slow down production. If you can sell oil now for $36 and in June for $51, why pump any now? Save it for later and boost production during higher prices, right?

Well, they are not doing that. Production is still at 99.6% of what was pumped at June’s record highs. The question is why. There are two theories. Generally, oil-producing companies are not the most forthcoming with reliable facts, so it’s hard to confirm either one.

First, consider that there’s a global liquidity crisis, collapsed asset prices, and instability in the Middle East. Could oil-producing countries be hard up for cash?

Middle Eastern countries make about one-fifth the revenue they did in June because of oil prices. And they invested heavily in American stocks that are down 44% off their peak. If they got a little reckless during the boom-times… they may have more bills than they can cover right now.

So while they may be able to make more in June, they need to get any money they can right now… leading them to sell oil at depressed prices.

The second possibility is that production is already maxed out. If the 85 mbd they are producing now is the max they could produce in June, there’s no incentive to slow down production now, because they can’t ramp it up when prices are higher anyway. (Slowing down today would still pay off in the very long-term… but it seems no one thinks on that time frame in the financial world anymore).

Each of those scenarios leads to a different way for the average American investor.

Profits for Those of Us Who Aren’t Oil Barons

In the first scenario, the Middle East cash grab, expect investment in storage to pick up. Companies like Teekay (NYSE: TK) and Frontline (NYSE: FRO) that manage and lease tankers should get a boost. As well as refiners like Valero (NYSE: VLO) and Marathon Oil (NYSE: MRO) as they take in extra crude at low prices.

In the second scenario, maxed out capacity for oil producers, drillers and explorers will return to prominence. Expect to see a resurgence of offshore oil drillers like Transocean (NYSE: RIG) and Atwood Oceanics (NYSE: ATW) and on-shore drillers like Nabors Industries (NYSE: NBR).

At the White Cap Report we’re currently scouring for some smaller cap innovators providing new niche technologies to oil providers. As oil marches back up to more reasonable valuations in the $50 to $70 range, oil companies will want to increase production… but with smart and efficient technology.

In any case, there are two things that won’t last for too long: oil contango and low prices.

Comments

[Chris B:]

"Well, they are not doing that. Production is still at 99.6% of what was pumped at June’s record highs. The question is why."

The difference between fixed and variable costs is the reason. If you've already built an oil well or rig, you have to pay the fixed costs of interest, depreciation, insurance, etc. even if you shut the pump down. Your variable costs can drop if you shut down production, but this is a minor part of your expenses.

Suppose your rig can produce oil at $60/bl and your fixed costs are $50/bl and your variable costs are $10/bl. With oil selling for $30/bl, you lose less money by pumping oil (30-50-10= -30) than you would if you shut down (fixed costs only = -50). When everyone does this, supply stays inelastic despite violent price swings.

New exploration & development has almost completely shut down, so global production totals through 2009, minus actual OPEC cuts, would be an accurate and interesting measure of deplection. I hope someone is studying this.

Jan 16 04:10 PM

[Alex Filonov:]

The reason for contango: there is a lot of oil coming in which was sold in June-July for $100+. It's coming in now, producers already locked price for it, so demand on the spot and near-term markets is much lower than expected. Probably there was less oil sold for delivery in June. But those who is speculating on contango now will bring June price down, because there will be a lot of oil coming with price locked at $50+. Story repeats until last year's oil futures bubble completely worked out.

If you think that oil is going up, just buy USO. Much simpler than buying companies. Besides, you don't know exactly how these companies hedged oil on future markets and hedging might affect results much more than current price moves.

Jan 16 04:34 PM

[Maxe Paul:]

I dont understand why oil at $50 to $60 is a reasonable price. It was not reasonable at that price, or $90, or $150. It is not even reasonable at $40 a barrel. In $US dollar weighted terms i consider it reasonable at $20/$25 a barrel.

Oil must return to a more sustainable price given the now dead economic outlook. Once we start driving smaller cars with lower consumption and clean fuels, oil will not see these ridiculous prices again for many many years, and "Amen" for that.

Jan 17 08:28 AM

[ROLEX18K:]

Oil cantango will last few years, 1 or 2 as this is about time the market needs to figure out exactly what's going on.
I don't know about 7 ways to make money, I know only 2 ways, one is buy the other is sell and it doesn't matter if one buys/sell for 1 minute or one year, there are only this 2 things trader must figure out to profit.
I chose in Crude Oil SELL order for futures 1-2 years to go as contango has to amortize and trade with the lower bias as the spot price does.
Expect Oil at 10-20 by 2010-2011.

Jan 17 08:35 AM

[Robert Wein...:]

Matt Weinschenk good article.

I have been selling USO puts as of about two weeks ago as I feel oil is either at a bottom short term or reduction in pricing will slow down to the point that options will be profitable. So far so good as the USO 26 Jan puts I sold exp yesterday totally out of the money

I don't think oil cant continue down, I just don't think that oil will go down fast and/or stay down. At least not below 20 for any real length of time.

Jan 17 10:55 AM

[donzelion:]

I like oil as an inflation hedge, through USO rather than the stocks, or better still, stable, dividend paying majors like BP or TOT, as opposed to speculative plays like RIG (which I've seen almost as many positive nods about as I did for Krispy Kreme, Garmin, and Crocs, once upon a time).

Oil could stay down for years - BUT the dollar will probably fall down as the debts come due.

Jan 17 12:19 PM

[ivoryjoe007:]

im not that expierinced in this field...but this is politics people. they just had the american public payin over 4 dollars a gallon for gas and we couldnt do anything about it..oil is going back up. these low prices are a head fake..until people go back to work and the american consumer starts to save a little money..then they ll be back to get what we saved..i look for oil to be 60 plus in the near term 6-12 months and close to a 100 plus after 18 months....

Jan 17 02:44 PM

[fairguy:]

maxe, who is gonna buy small cars when oil stays <50? Just take a look at prius sale, down 40-50%. Even if oil goes to 60-80, americans are too poor to junk their old gas car to buy a electric or hybrid car that cost 2X as much as a regular car.

Jan 17 03:56 PM

[rver19261@e...:]

Please, some one explain USO and if it is not a stock, how do you follow it............Louis

Jan 17 08:08 PM

[jgonion:]

This piece considers two scenarios to why OPEC as not cut production as if they are the only two possibilities: Either the OPEC states are short on cash, or they are already maxed-out on production.

Consider the fact that OPC's oil-fields were developed back in the 70's, giving OPEC the lowest cost-of-production of any oil-producing state. Far from running out of cash, this pricing power gives OPEC the ability to keep oil prices low, which will hurt other oil-producing ventures far more than it hurts OPEC. For example: Oil-sands, Shale-oil, and even domestic oil production that has yet to amortize exploration & development costs have far higher costs of production than OPEC does.

So why would they want to cut production and increase prices? Even though prices may go up, this does not balance fewer barrels of oil shipped. Raising prices by lowering production gives OPEC less revenue while also helping their competition (who have higher production costs) to be profitable.

Among other things, OPEC is a collection of savvy businessmen that understand how the oil markets work very well. Coming out of this global recession, the worse financial shape non-OPEC members are in, the better positioned OPEC will be, and they know it.

Why isn't OPEC reducing production? It's simply bad business.

Jan 17 08:26 PM

[Keith Labre...:]

you could look it up...
I did, at Yahoo finance:
finance.yahoo.com/q?s=...

It's an ETF (EXchange Traded Fund)

United States Oil (USO) On Jan 16: 29.86 0.32 (1.06%)
U.S. OIL FUND ETF(NYSEArca: USO)


FUND SUMMARY
The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil. The fund is nondiversified.



On Jan 17 08:08 PM [e-mail]... Louis wrote:

> Please, some one explain USO and if it is not a stock, how do you
> follow it............Louis

Jan 17 10:40 PM

[User 339656:]

DO NOT BUY OIL!!!

SELL IT!!!

Jan 18 12:30 PM

[User 339656:]

Look at the forward curve:
www.finanzen.net/rohst...

Jan 18 12:33 PM

[Timmothy Posey:]

DXO is 2x the performance of crude oil.

Jan 18 01:10 PM

[Pessimistic...:]

I remember last week reading that NAT was one of those mke shift off shore storage facilities and now adding that newly purchased tanker to join the fleet. Are they still in that position? Wouln't they also be in the postion to profit from this hold?

Jan 18 05:36 PM

[Channon:]

Alex Filonov - Are you saying that too many contracts are being bought? Simply put, too much oil will be delivered in June (at $50) than will be demanded, and thus the spot price come June will also be depressed?

Jan 21 12:37 AM