The End Of Crude Oil Contango: What It Means For Oil Refiners (And Oil Prices)

by: James Shell

Contango is the condition in a futures market when the out month contracts are higher priced than the near month contracts. The crude oil market was in this condition for nearly 3 years, until last week, when the market flipped to the more normal "backwardation" state. In the last few days, what with the gyrations in the financial markets which have spilled over into the oil pit, the contango has hovered on either side of zero.

If we're in a new regime where the backwardation returns, there are several potential impacts of this situation that will affect the oil price as well as the bottom line in companies that do oil refining.

Here is a graph of the 3-month contango in crude oil for the past couple of years:

The average contango for this time period was over $2 per barrel, with spikes in the spring as the contracts extended into the summer refining season. What this meant was essentially an average $2 risk reduction for owners of either the oil or the contracts.

The knock-on effects of this are well known. If you pay someone to keep inventory, he will, and commercial crude oil inventories in the last couple of years have been exceptionally high, particularly in the US midwest, and in particular, Cushing OK, the FOB point for the WTI contract.

Source: Energy Information Administration (.pdf)

In fact, a little industry developed in the Gulf of Mexico since it became possible to store oil at near zero cost, because of low tanker rental rates. There was also a $2 risk reduction for any speculator who was long on crude oil because of the long term upward bias in the market.

On average, with the exception of a couple of periods in the spring of each year because of the summer driving seasonality, the market for unleaded gasoline (RBOB) has remained in backwardation:

The average backwardation of the RBOB market is $1.24. So, knowing that, the refiners could get a little additional crack spread by buying and storing crude oil, but selling the finished product in the front month. That's why the inventories of RBOB remained at normal levels at the same time the crude oil inventories increased.

Source: Energy Information Administration (.pdf)

So if (and it is by no means certain) the contango really is at an end, what are the ramifications?

The first effect should be a drawing down of inventory.

Here are a couple of graphs that illustrate the rough correlation between degree of contango in the oil futures market and the actual inventory in Cushing OK: I am not about to do the regression analysis, but it is clear that at least since roughly July the owners of oil have gotten the message and lightened up on inventory:

There is a historical precedent as well. In July of 2007, a two year period of contango came to an end and between then and January of 2008, the commercial crude oil inventories went from 355 million barrels to 285 million.

So the first effect of the inventory drawdown should be a downward bias in crude oil prices as the owners of oil liquidate their inventories and take pressure off of the markets, and the speculators will no longer have a $2 risk reduction for going long on a contract and sitting on it.

What about the effects on the refiners?

We know that the refiners have been announcing earnings this week, and they have been exceptionally high because of high crack spreads despite relatively low fuel demand because of the unusual situation that has developed because of the spread between WTI and Brent. The Valero (NYSE:VLO) announcement did mention the idea that fourth quarter crack spreads will be lower.

The P/E ratios for this little group are as follows:

Trailing P/E Forward P/E
Marathon Petroleum (NYSE:MPC) 7.42 5.88
Holly/Frontier (NYSE:HFC) 9.9 5.59
Sunoco (NYSE:SUN) NA 17.75
Valero (VLO) 20.82 5.9
Tesoro (TSO) 10.03 6.61
Calumet (NASDAQ:CLMT) 25.87 10.72
Western Refining (NYSE:WNR) 13.42 4.71

On the whole, these stocks are trading lower than the typical 8-9 times historical earnings for this group, and normally I would suggest that it is time to get on board with some of these stocks, but the market has discounted the analysts' earnings estimates considerably.

So the bottom line is this:

If the backwardation situation persists, you can expect downward pressure on oil prices and also on crack spreads, and the market is correct in discounting the oil refining group, and if you did not take my sound advice of July and lighten up on this group, now would be a good time to do so what with all of the overachieving earnings announcements coming out this week.

If the contango returns, and the analysts are more correct than the market, some of these companies are buying opportunities at the current P/E levels, knowing what we know about the continuing crack spread situation.

As we always say, the world is full of peril and there are no guarantees on anything, but continued monitoring of this contango situation should give us a clue as to what will happen in the next few months.

Disclosure: I am long CLMT.

Additional disclosure: I still like CLMT because of its excellent dividend. I am not too thrilled about the stock going down since I bought it, but I'm going to have about 6.5% dividend income on my 9-month investment.