Four Ways to Capitalize on 'Super Contango'

Includes: KMP, OIL, TK, USO
by: Keith Fitz-Gerald

Many investors have given up on oil, fearing that a fall from grace precludes a rise in price from the ashes. But it’s worth noting that the oil markets are right now in a rare state of ’super contango,’ which suggests that the markets expect far higher prices by next year.

Here’s what you need to know.

In case you’re not familiar with the term, ‘contango‘ denotes a normal and very specific condition associated with futures contracts in which the price of oil for distant delivery months from now exceeds the price of oil being traded right now on the spot market. Typically, the price difference is related to the cost of storing and insuring the oil itself.

An example might help. On Tuesday, oil traded at $38.81 a barrel on the New York Mercantile Exchange spot market. So if we bought a barrel and put it into storage for the next five months, and assumed that would cost us 90 cents per barrel per month, under normal market conditions, we’d expect the June crude oil contracts to be priced roughly at $43.31 ($38.81+ the cost of storage for five months = $43.31).

However, according to the New York Mercantile Exchange, June crude oil contracts settled at $52.14 on Tuesday, which represents a state of ’super contango’ - and an excess potential profit of $8.83 per barrel ($52.14 - $43.31 = Excess Potential Profit of $8.83). But only for traders who can buy oil now and store it until then.

There are obviously wrinkles, of course, depending on where the oil is stored and how it is priced for delivery. But, in general, the spreads we’re seeing now are at, or near, their highest levels since April 2004, when the government started collecting Cushing data. Cushing is the delivery point for all NYMEX futures.

Super contango is a rare situation that causes most traders to drool - myself included - because it signals an arbitrage opportunity that’s literally too good to pass up if you’ve got the means to capitalize on it.

But, as usual, there are all sorts of unanticipated consequences - including a phenomenon we don’t see very often - hoarding at sea.

Tanker rates are skyrocketing as companies literally top off very large crude carriers with the 2 million gallons they’re designed to carry - and then park them offshore until prices rise. In the meantime, they’re also selling the June futures and locking in profits above and beyond what it costs them to buy and store their stash of this ‘black gold.’

Of course, with every tanker that’s stuffed to the gills as a storage container, there’s fewer of the big boats in circulation. And that’s caused benchmark supertanker rental rates to rise more than 56% since Jan. 1. But the perceived profit potential is so high right now, that even investment banks, which are hardly in the market for super tanker rentals under normal circumstances, are getting into the game.

According to recent reports by Bloomberg News, Phibro LLC, the commodities trading arm for Citigroup Inc. (NYSE:C), has booked two supertankers to hoard crude oil supplies. Phibro recently stationed the 1 million-barrel carrier ‘Ice Transporter’ off the coast of Scotland and the ‘Ashna’ waits patiently on the U.S. Gulf Coast. Assuming they capture the entire $8.83 a barrel in excess profits we cited in our example, that’s a cool $8.8 million in the bank, just from the Ice Transporter cargo alone.

Based on my experience, traders tend to run in packs, so it’s highly likely that all the usual suspects are involved including most notably Morgan Stanley (NYSE:MS), which owns half of tanker group operator Heidmar Inc. and Goldman Sachs Group Inc. (NYSE:GS), which executes commodities trades and structures related deals through J. Aron & Co.

As many as 80 million barrels of crude are being stored at sea around the globe, according to Frontline Ltd. (NYSE:FRO), the world’s largest owner of supertankers. That’s nearly enough to supply the entire world’s demand for a day.

As for what caused the super contango, the most common and widely accepted argument is that falling global demand has caused a current glut in supply that will be rectified by production cuts by the Organization of Petroleum Exporting Countries (OPEC) later this year. That’s certainly plausible and there is no shortage of data to support this contention.

‘That’s really what they’re betting on,’ said Opportunities in Options‘ Paul Forchione, a veteran trader with 30 years in the commodities markets. ‘A significantly higher price for the deferred contract month in excess of storage and insurance costs typically means traders expect demand to grow in the future.’

In his experience, Forchione said that ‘this situation is hardly the panacea that everybody thinks it is because it’s hard to put a limit on how far out of whack prices can get.’

However, there’s also another plausible explanation that seems entirely likely, based on conversations I’ve had with traders, officials and company officers in the oil business all around the world.

Basically, the super contango we’re seeing now could suggest that future pricing is as much about the fear of supply interruption as it is about present demand dropping. And that’s entirely logical given the constant state of warfare in the Middle East, threatened production in Africa, an unsteady South America, and China, which is structuring oil-supply deals with rogue nations as fast as it can.

I know from having addressed crowds of investors all over the world that this seems impossible, but at a time when China and India, for instance, are doing everything they can to stave off a global recession, it’s certainly not inconceivable. Moreover, if this is even remotely true, as a growing trail of evidence suggests, then the present super contango could also imply that traders believe oil will be increasingly hard to find, refine and transport in the months ahead. That, too, suggests higher prices to come.

Now for the million-dollar question: What can investors do about it?

The most obvious choice for investors who think prices will indeed be higher come next June is to buy any of the half dozen oil-related ETFs. That includes The United States Oil Fund LP (NYSEARCA:USO) or iPath S&P GSCI Crude Oil Total Return ETF (NYSEARCA:OIL).

The problem, of course, is that the spreads companies are counting on for profits could drop rapidly between now and then. This would force companies currently hoarding oil to begin dumping it, thereby reinforcing even lower prices going forward. There is also the possibility that OPEC production cuts never happen, or are ineffective, which would also point to lower prices.

History suggests that far safer bets include mid-process transportation companies like TeeKay Corp. (NYSE:TK) or land-based alternatives like Kinder Morgan Energy Partners LP (NYSE:KMP). Both pay healthy dividends that can help stave off a personal recession no matter what happens with oil prices. That’s always important in rough markets.

For futures-savvy investors, there’s an even more direct bet. Data shows that ‘mean reversions’ are particularly powerful phenomena when it comes to commodities, so the fact that spreads have risen to all-time highs suggests that it’s only a matter of time before they reverse. One way to potentially capture that would be to buy March futures while selling June futures.

Risk management is paramount, regardless of which path investors choose. Super contango sounds too good to be true and we all know the old adage: If it sounds too good to be true…

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