Oil Futures: Money for the Taking?

Maybe someone who knows more about oil than I do can explain this to me. As best I can tell, there is money for the taking, at virtually no risk, available in the oil futures market right now. As an economist, I have a hard time imagining how that can be: when there is money for the taking, we usually assume that someone will already have taken it.

Physical oil is selling for about $50 a barrel today. Just for a specific example, the contract for May delivery of light, sweet crude closed at $49.88 on the NYMEX Thursday. Distant futures contracts, however, are trading at much higher prices, a situation known as contango. Ordinarily contango can be explained by the costs of financing and storage, but today’s contango seems too extreme to admit of that explanation. For example, the December 2010 contract closed at $66.68 Thursday – more than 33% higher than the May 2009 contract.

It seems like a no-brainer: buy some oil, put it in a tank, sell the distant futures, and then just wait. Some time between now and December 2010, either the price of the oil has to go up, in which case you make money by selling the oil, or else the price of the futures has to come down, in which case you make money by buying back the futures contract. The costs of financing and storage can’t be anywhere near large enough to eat up the profit that you’re locking in with these transactions, and the basis risk – the risk that the oil you buy won’t sell for exactly the price of the deliverable oil for the futures contract – has got to be tiny compared to the available profit.

If you annualize the difference in the futures contracts, it comes to 20.1% or $10,036 for 1000 barrels of oil. Admittedly knowing little about the market, I just can’t imagine that it costs more than a few thousand dollars to store 1000 barrels of oil for a year. So we’re looking at an implied financing rate in the high teens. If you can finance, say, at 10% (which shouldn’t be too hard for a well-established institution that can offer 1000 barrels of oil as collateral and show that the futures contract will assure the ability to pay back the loan), you can pocket the difference.

Anyhow, we don’t really need to talk about the financing and storage costs for a hypothetical arbitrageur that needs to borrow the money and store the oil. There are plenty of oil producers that have the option of storing the oil in the ground at zero cost. Unless they’re desperate for cash (which seems unlikely given the amount that many of them piled up when oil prices were high), it’s a puzzle why they continue producing at over 90% of capacity. Why not just sell the futures, put off the extraction until late next year, and either sell the oil at a higher price or buy back the futures at a lower price?

And even if they are desperate for cash, it’s still a puzzle. Given the huge amount of highly liquid US Treasury bills in circulation, it’s clear that not everyone is desperate for cash. Some are just highly risk-averse and don’t want to invest their cash right now. But this arbitrage offers them a risk-free investment with a return much higher than that of T-bills: pay an oil producer today for some oil to be delivered in December 2010, sell the futures contract, and then wait. You can offer the producer more than today’s price of oil, so it will certainly be in the producer’s interest to accept your offer: they get the cash now, and they don’t have to send the oil until later. Meanwhile you’re assured of making money come December of next year: you either re-sell the oil at a higher price as soon as it gets delivered, or you buy back the futures contract at a lower price.

Everything I know about economics says that there ought to be so many people trying to do these transactions that they would already have driven up the price of oil or driven down the price of the futures contract to the point where no obvious risk-free transaction is possible. So why hasn’t it happened?

Disclosure: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Comments

[pockyclips ...:]

When big oil is leasing tankers to use as storage tanks, that can't be cheap. When demand picks up, this "storage " capacity will go extinct, and prices will spike due to lack of drilling now.

Apr 17 09:27 AM

[MarkitWacha:]

It would seem that the difference in price between the two contracts reflects the market's expectations on the cost of carrying more than anything.

If that's true, then this difference would make a good leading indicator for an oversupply condition in the oil markets. It would still be necessary to take into account opportunity cost, financing rates, and cost of storage.

Apr 17 11:26 AM

[MarkitWacha:]

I just thought of something.

A swimming pool holds 30,000 gallons.

A barrel of oil has 55 gallons. The contract is for 55,000 gallons.

Were it not for city ordinances and regulations, you could fill two swimming pools with oil and pay yourself ~$500/month for holding the oil.

Apr 17 11:35 AM

[happycajun:]

MarkitWacha - you are clearly not an oil patch kinda guy/gal - a barrel of crude is 42 gallons - interesting history of the "blue" barrel and early standardization of measure in the oil industry behind that conversion factor. As someone who has waded waist deep in A-Light crude, you'd have one hell of a clean up job, not to mention weathering loss (evaporation) and the risk of catastrophic conflagration (i.e., one hell of a fire).

Regards, HC

Apr 17 11:55 AM

[SJD:]

What we are talking about here is contango. By the way, a barrel of oil is 42 gallons.

Apr 17 11:58 AM

[j'adoube:]

Yeah, Markitwatcha, remind me where you live. I want to buy some puts on housing values in the area, as there's a non-trivial chance they go to zero when someone drops a match in your pool.

Apr 17 01:00 PM

[Alex Filonov:]

Looks like there is not enough storage capacity. Plus there are a lot of contracts which are pure hedges, and some big consumers are still hedging oil even at contango prices. For example, Southwest lost a lot of money on hedges they did last year and they still bought hedges through 2011. Looks like there are not enough future sellers

Apr 17 01:18 PM

[Munim:]

Sorry guys. i might make a complete fool of myself by asking this
what are contango prices?
i am enjoying reading articles and discussions. want to learn more :)
Regards
Munim

Apr 17 01:49 PM

[Munim:]

Also why would the same not apply to a stock where
you hardly have any holding cost. Say i buy a stock at this moment and sell the next year's futures which is trading at higher prices???
Pardon if this is too naive.. :P but why should that nt work

Apr 17 02:01 PM

[Ferdinand E...:]

The big problem of course is the lack of storage facilities. Talk has been going around about building ships exclusively for the purpose of storing oil.

Apr 17 02:21 PM

[DougM:]

It certainly seems true that storage is maxed out on this trade, but the underlying question is still hanging out there. Producers have (in effect) unlimited storage. So if this was such a great trade, you'd expect them to be piling into the long end of the curve selling contracts like crazy against future production while simultaneously reducing current production levels.

Apr 17 03:43 PM

[DougM:]

In thinking about the producer's situation a bit more, it occurs to me that in trading off some lower current production for higher future prices, there's a cash flow issue. Selling (shorting) a futures contract might not generate a near-term cash flow for the producer; in fact, they might have to post some margin against the position to carry it to expiration. Worse still, the contract is denominated in dollars, the value of which are hard to predict the farther into the future you look.

Apr 17 03:50 PM

[JayQ:]

Munim, the reason why that would not work with a stock, is because with a stock you would be selling an option not a contract. The buyer would have the option to buy, but would not be obligated to do so.

Apr 17 04:15 PM

[Madarasi:]

Hi
I need some clarification on this strategy since it looks intriguing at the offset, but I am not sure of the mechanics (especially the arbitrage claim). I am a newbie in futures, so please correct me if I am wrong.

Let us suppose this scenario:
1. We buy the physical commodity and store it and put up capital to buy it (let us assume no need for margin or any other financing, we just have the capital sitting in 0% yields and we would just buy something instead of keeping the cash)
2. We sell the Jan 21010 futures at 20% above the spot price (assume spot = $50 and future = $60)
3. The crude oil price simply crashes and reaches the current spot price (from $60 to $50) by Jan 2010
4. We buy back the long dated futures and made the spread of $10 and close the future transaction.

Till now we are good. Now what happens to the barrels of oil we have got stored and the price continues to crash further to $20 and doesn't recover for a few years.
How would this be an arbitrage? My understanding of arbitrage is that it has to be risk free. I don't see it as risk free.

But it is risk free (assuming no oil blowups where we stored it by skimping on insurance etc.,), if we don't buy back the contract which will force the contract buyer to take supply of the commodity.

I would appreciate it if someone can help me understand this better (a link to articles and/or futures books would be fine too).

Thanks
VV

Apr 17 05:22 PM

[earljr:]

It would seem there is little reason for anyone to produce oil right now. Since producers have zero storage costs, why would they sell at $50 if they can sell at $66? Well, storing in the ground is not like storing in a tank. They probably can't pump April's oil and December's oil all in December. They can only get so much out at a time. And the need for cash flow forces them to pump both months' volume. However, any company that can basically open the spigot wide on demand (like a storage tank) could be a very interesting investment right now. Anybody have any ideas?

Apr 18 08:11 PM

[dakkoune:]

Most of producers are State Companies and they are obilged to produce the Maximum oil to satisfy their govemnet Budget to rule the country Peacefully therefore even if prices pulldown to $ 25 there will be more oil in Market from Producers to compensate low price they have to pump more and more .

Apr 19 04:48 AM

[Alex Filonov:]

Risk free trade is for you to buy oil on the spot, put it in the storage and sell future contract at the same time. Don't buy back your contract, just deliver oil on expiration. Your profit is the difference between spot price and future price, minus storage expense and commissions.


On Apr 17 05:22 PM Madarasi wrote:

> Hi
> I need some clarification on this strategy since it looks intriguing
> at the offset, but I am not sure of the mechanics (especially the
> arbitrage claim). I am a newbie in futures, so please correct me
> if I am wrong.
>
> Let us suppose this scenario:
> 1. We buy the physical commodity and store it and put up capital
> to buy it (let us assume no need for margin or any other financing,
> we just have the capital sitting in 0% yields and we would just buy
> something instead of keeping the cash)
> 2. We sell the Jan 21010 futures at 20% above the spot price (assume
> spot = $50 and future = $60)
> 3. The crude oil price simply crashes and reaches the current spot
> price (from $60 to $50) by Jan 2010
> 4. We buy back the long dated futures and made the spread of $10
> and close the future transaction.
>
> Till now we are good. Now what happens to the barrels of oil we have
> got stored and the price continues to crash further to $20 and doesn't
> recover for a few years.
> How would this be an arbitrage? My understanding of arbitrage is
> that it has to be risk free. I don't see it as risk free.
>
> But it is risk free (assuming no oil blowups where we stored it by
> skimping on insurance etc.,), if we don't buy back the contract which
> will force the contract buyer to take supply of the commodity.<br/>
>
> I would appreciate it if someone can help me understand this better
> (a link to articles and/or futures books would be fine too).
>
> Thanks
> VV

Apr 20 03:02 PM

[Dan Palmer:]

As a real estate developer, I am intrigued by the idea of building the needed storage facilities in the right loocations. Any suggestions where to start? Or, brokers that deal in those sorts of properties?

Apr 20 11:08 PM

[Munim:]

@Alex
Initially it was suggested that if contract prices drop buy back the contract and make profit on spreads. Now what do we do with the Physical oil we have bought at spot?


On Apr 20 03:02 PM Alex Filonov wrote:

> Risk free trade is for you to buy oil on the spot, put it in the
> storage and sell future contract at the same time. Don't buy back
> your contract, just deliver oil on expiration. Your profit is the
> difference between spot price and future price, minus storage expense
> and commissions.

Apr 22 06:32 AM

[Madarasi:]

Yep. That is the arbitrage trade.
Thanks
VV


On Apr 20 03:02 PM Alex Filonov wrote:

> Risk free trade is for you to buy oil on the spot, put it in the
> storage and sell future contract at the same time. Don't buy back
> your contract, just deliver oil on expiration. Your profit is the
> difference between spot price and future price, minus storage expense
> and commissions.

Apr 29 02:27 PM