John Hussman: Assessing Oil in Contango

Excerpt from the Hussman Funds' Weekly Market Comment (5/27/08):

Normally, the oil futures curve is in “backwardation,” which means that futures prices for distant delivery dates trade below the current spot price for oil. Occasionally though, longer-term futures trade well above spot prices, even adjusted for interest rates and cost of carry. Often a contango emerges during a period when the spot price of crude is declining – usually with a resulting acceleration in the decline (as we observed several times during the 1990's). In recent days, we've observed a contango develop between spot crude and futures expiring in 2010 and beyond, while the spreads between near-term futures have narrowed sharply and may also move into contango soon. This is worth monitoring. It is a sign that traders have accepted the bullish case so thoroughly that they have become frantic to bid up oil for delivery well into the future.

Contango creates immediate incentives to buy oil for near delivery and store it in inventory. Producers don't particularly like markets in contango, because that tendency to build inventories reduces their ability to control prices through their own actions.

Just as stocks tend to be poor buys in overbought markets with extreme advisory bullishness, commodities tend to be poor buys when prices have already enjoyed a parabolic speculative rise and futures move into contango (with the caveat that the last few weeks of a speculative rise can be nearly vertical, so the ultimate highs are unpredictable). A few years ago, the tendency of oil prices to increase despite a mild contango made it appear that the relationship between contango and subsequent price weakness had vanished. But as the contango steepened in 2006 and early 2007, crude plunged from about $80 to nearly $50 a barrel. I emphasize – this was just a year ago. We probably shouldn't assume that the world has suddenly changed so dramatically that the demise of fossil fuels and the extinction of mankind as a species has to be priced in by Labor Day, and then continually revised so that prices form an ever steeper parabola.

Comments

[jjason:]

You mention speculation. What do you think of the article by Phil Davis (on SeekingAlpha this week) where Phil shows how the speculators in oil futures contracts have run up the price of oil?

Also, follow the links that Phil gives and you will see a
Congressional Report involving 16 US Senators, dated March 5, 2003, that has some excellent comments on price fixing.

There are people who comment on this board who are part of the price fixing problem and who deny that the hedge funds, non-commercial buyers, ICE, NYMEX, and others have nothing to do with speculators artificially increasing the price of oil and other commodities .

If consumers around the world are getting cheated by the current system then something should be done about it. Everyone should know what Enron's management was able to do to cheat the public, pension funds and shareholders.

I would appreciate it, John, if you would read Phil's article and the Congressional report and comment on this subject.

Thanks.

2008 May 30 10:45 AM

[Steven Ward:]

The price rise of oil, more than doubling, in just 18 months cannot hold. Chinese hoarding for the Olympics, Iranian hoarding, speculators leaving the dollar and buying oil, all add up to something greater than demand even though demand is greater than last year and will continue to rise.

Something gives very soon in the next 6 months.

2008 Jun 02 03:36 AM