How to Trade (or Dance) the Oil Contango

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 |  Includes: BHI, BNO, BP, CVX, ESV, HAL, NE, OIH, OIL, RDS.A, RIG, SLB, TOT, UGA, UHN, USO, XOM, XOP
by: Kenneth D. Worth

There are two key issues in the oil market these days: 1) Why is the contango in WTI futures so persistent, and 2) Why is there an $8 premium of Brent crude relative to WTI, which is a lighter, sweeter (i.e. traditionally more expensive) oil? The usual discount of Brent to WTI ($1 to $2 per barrel) seems a thing of the distant past.

Various arguments are presented: Canadian pipelines coming on stream, a Valero refinery shutdown, full storage tanks in Cushing, Okla., (the delivery point for WTI) etc.

I'll offer a different view. Crude oil prices are high all over the world: Brent, Dubai, Indonesia, Nigerian Bonny Light. All are close to or already above $100 a barrel. Only WTI seems to lag. The Friday close on Nymex was $89.11 a barrel.

The common wisdom is that speculators can affect the price of oil. Indeed, speculators are often blamed for the run up in prices whenever they are high. But maybe it's the speculators who are to blame for the low price of WTI. Maybe all those institutions dumping the front month contracts to get out of having to take delivery are depressing the price of WTI delivered in Cushing, Okla., relative to other world crudes, to the benefit of Midwest refiners. Just a thought.

WTI has a significant contango that seems almost constantly stuck with us. And yet there is no contango in Brent, no contango apart from normal seasonality is wholesale gasoline, no contango apart from normal seasonality in heating oil.

What does this mean for investors? Well, first of all, avoid USO and OIL like the plague. These ETF's are being crushed by the continual need to roll over their contracts to the front month. Their performance over the past year relative to other oil investments has been very disappointing. Second, focus on the smaller less liquid instruments not favored by the big institutions. These include Brent crude (no contango), the ETF is BNO; wholesale gasoline (again no contango apart from normal seasonality), the ETF is UGA; and heating oil (again only normal seasonality), the ETF is UHN.

Sure, if you think oil is headed higher due to higher oil prices, you could buy drillers like Transocean (NYSE:RIG), Baker Hughes (NYSE:BHI), Noble (NYSE:NE) and Ensco (NYSE:ESV). You could buy the oil service companies Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB) or the ETF OIH. You could buy the smaller exploration and production companies (easiest done through the ETF XOP. There are always the majors: Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), BP (NYSE:BP), Shell (NYSE:RDS.A) and Total (NYSE:TOT). But these investment vehicles are stocks, and while they will benefit from higher oil prices, they will trend downward or sideways in a bear market, should this year give us another one, entirely possible given the pricey nature of the overall market and the uncertain economic outlook.

Investors wanting a pure commodity play on the oil market have options apart from the usual suspects, which have severely lagged crude oil prices, not to mention the prices you and I pay at the pump.

Disclosure: I am long XLE, XOP, OIH, UGA, BNO.