What's Cooking with the Oil Price Contango?

Includes: OIL, USO
by: Tradesense

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contango or forward premium is the order. Furthermore, the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

Since the Eighties, WTI has ruled the global crude oil market. As it is produced and refined in the US, the world s largest consumer and importer of crude oil, it has been widely accepted as the best indicator of global demand-supply. Nymex WTI contract is the largest market for this crude oil.

Brent oil is pumped out from the North Sea and shipped to Europe, Russia and parts of Asia. Oil from Europe, Africa and the Middle East flowing to the West tends to be priced relative to this oil, i.e. it forms a benchmark. However, large parts of Europe now receive their oil from the former Soviet Union, especially through Russia.

Traditionally, Brent traded at a discount to WTI because it is less light and less sweet.

From the charts below it can be seen that the differential between the near/front month contract between WTI and Brent started appearing toward the end of 2008. Also note the Dec09 contracts have shown very little differential.

So what’s cooking?

One explanation that I have come across is:

…it is becoming more expensive because the North Sea oil fields are getting depleted. But that doesn’t explain its premium over WTI. On the other hand, WTI was clearly over-supplied. The problem was created by the very nature of the WTI market. The WTI market has a large number of independent producers who sell their crude based on posted price. The oil is then brought into Midland and sent to either towards the Gulf Coast refining areas or towards Cushing, Oklahoma. Cushing is an oil-trading hub and the delivery point for NYMEX light sweet crude oil futures contracts. Due to pipeline logistics, once the oil flows outwards from Midland towards Cushing, WTI can only go in one direction: towards Chicago.

So if refineries in Chicago want less oil, you can’t divert the oil towards other places where there might be more demand. In the last three months, several factors led to large supplies of oil flowing into Cushing.

However, demand for crude has come down as it is reported that the refineries' off take has fallen given that the refining margins are wafer thin or negative. This has reflected in the pump prices going up.

Now what’s happening in Cushing? NYT explains:

A year ago, oil producers and refiners could not move their products fast enough to meet growing world demand and chase rising prices. Now, with demand and prices slumping, they are sitting on 327 million barrels at tank farms around the country, particularly at Cushing, Okla., a major storage hub and a crossroads for pipelines. That is more than 40 million barrels more in storage than this time last year, and more than 30 million barrels higher than the five-year average. The mounting buildup has come during the last 100 days or so, as consumption of oil fell behind imports and domestic production.

In this context note that:

The International Energy Agency predicted that the worsening global economy will leave demand at 85.3 million barrels a day _ 0.6 percent lower than 2008. Demand last year is estimated to have slid 0.3 percent.

The IEA says it lowered its forecast because it has nearly halved its estimate for global economic growth to 1.2 percent.

U.S. petroleum deliveries _ a measure of demand _ fell 6 percent to 19.4 million barrels a day last year, with declines for all major products made from crude, according to the American Petroleum Institute.

The Organization of Petroleum Exporting Countries has also lowered its energy demand forecast for 2009, saying in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009 from the previous year.

The demand destruction is further evidenced by the fact that:

From the Indian Ocean to the South Atlantic to the Gulf of Mexico, giant supertankers brimming with oil are resting at anchor or slowly tracing racetrack patterns through the sea, heading nowhere.

The ships are marking time, serving as floating oil-storage tanks. The companies and countries leasing them for that purpose have made a simple calculation: the price of oil has fallen so far that it is due for a rise.

Some producing countries are trying to force that rise by using the tankers to withhold oil from the market, while traders are trying to profit by buying cheap oil now to store and sell at a higher price later. Oil storage has become so popular that onshore tank capacity is becoming scarce.

…noted that a trading company could buy oil at the spot price of nearly $40 a barrel, store it and sell a contract to deliver it in a year for about $60. “You pay between $6 and $10 a barrel to store it, and you can make $10 a barrel”... “That’s why Cushing is filling up rapidly and people are leasing tankers..."

… With storage tanks filling up onshore, private and national oil companies, refiners and trading companies are storing another 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years, according to Frontline Ltd., the world’s largest owner of supertankers.

The different players have different reasons for storing oil, whether onshore or offshore.

As to why the futures are trading at such premiums the reasoning is that:

…OPEC has announced 4.2 million barrels a day of production cuts since September, moves that investors have so far ignored. But markets may be anticipating those output cuts will start to tighten oil supplies later in the year…

“The OPEC production cuts are going to take time to widdle away the build up in inventories," ... "But if compliance is high, that could support prices looking further out..."

Coming back to the question of WTI and Brent the question that arises is: “How can oil around the globe be priced by a small US location, which doesn’t have a safety valve to deal with a few million extra barrels of oil?” or should Brent become the benchmark as I understand it has no such logistics related bottlenecks, and therefore is Brent now reflecting a truer picture?

The jury is still out on this.

Disclosure: No Positions.