Crude Oil Contango
by Bob Ward
After a lot of thought on finding a lean way to explain the forward vs spot markets I've concluded the best method is to provide a bullet point outline of concepts with a few details included. I've added many tidbits using Crude Oil since that's the only contango anyone cares about right now.
The Forward market is a daunting subject that takes years to learn and is so wide in concept and intricacies that a few short words of explanation can barely cover the surface issues. And, as with most things, it is below the surface where all the dangers lurk for investors.
For instance, 99 out of 100 Crude Oil speculators and investors want to know nothing about Crude except what price they can trade it right now. They take for granted that any vehicle they use to trade Crude has all its costs displayed right up front - and they end up paying a fortune for that ignorance.
Here then is a work in progress outlining perhaps a few too many thoughts on spot / forwards / futures and contango / backwardation:
- The cost of holding most non-paper assets (commodities) is, to the dismay of investors, often far more than the original purchase price.
- Paper assets have relatively low costs to maintain and can be kept in a desk or lock box. This refers mainly to stocks, bonds, currencies, future and forward contracts/agreements.
- The more a commodity looks like, acts like, and trades like money, the less its cost of holding. For example, Gold, which has all the necessary qualifications to be money, is relatively easy to store and cheap to hold. This is not true of Crude Oil and many other commodities up to and including Real Estate.
- Each commodity market has its own specific cost factors to deal with and the pros in each market live for the day when the common investor falls in love with their market. That's when they get payback for surviving through the lean years. Until the common investors take the time to analyze their yearend statements in detail they never realize the size of the hammer that has been hitting them.
- In modern markets we have come to expect tremendous liquidity – the ability to trade anything at any time. This is only true because a huge common investor demand has developed (which profits the professionals) and has encouraged the creation of multiple markets operating in different time zones and locations across the globe.
- It is only when millions of common investors are giddy with hopes and dreams of profit that they are comfortable overlooking the many differences between markets. During the last several years it all became one huge trade to them, all markets going the same direction. As common investor demand ebbs each market shrinks and the true separateness becomes apparent -- making the smaller markets look like remnants on the beach at low tide. Arbitrage then fails because no one is willing to pay for or accept the differences between the markets any longer.
- Most world commodities have both a physical market and a paper market. The physical market is called the “Cash” or “Spot” market. The paper markets are created by making Forward or Future contracts / agreements. Since common investors hate taking physical delivery but love speculating on prices they do all their business in the Forward/Future paper markets. Therein lies the rub. Whenever the predatory players know your preferences they can outgame you.
- The unifying force that keeps Spot markets, Forward markets, and Futures Markets in line with each other is professional Arbitrage. That is, the physical markets and paper markets will not stay in line unless the professionals can arbitrage them.
- Total Fungibility makes arbitrage far cheaper and easier. Fungibility means that all items of a class are considered identical for delivery purposes. Two common examples: every share of IBM is equal and every dollar bill is equal. Without the simplifying concept of all items being identical there would be chaos in everyday life. But most commodities are not easily made fungible, which can and does create big problems.
- Crude Oil has dozens of different sub-types and is therefore not easily made fungible one barrel with another. Commodities and real estate parcels tend to have this same difficulty, not being easy to deliver in identical units. This makes arbitrage expensive and in some cases, impossible.
- When arbitrage is not possible the Spot markets can get far out of line with the Futures and Forwards markets. This is one cause of today’s Crude Oil contango distortions.
- In active commodity markets the physical and paper markets typically flow seamlessly one with the other. An uptick in one leads to an uptick in the other and so on. When millions of common investors pour their money in day after day, such a deluge of demand easily outweighs any minor market differences. These investors are blind to nuances of product quality and end user demand. Professionals can get away with selling Nymex Crude to them and buying any of a dozen other oil markets because there is enough profit offered by the impatient investors. It is only when the investors have run out of steam (the tide is going out) that the minor differences between markets re-emerge and become painfully apparent.
- The players in the paper markets tend to be far less sophisticated than the players in the physical markets. Sophistication in the ways of the markets, especially the physical markets is far more important than bankroll size as several former billionaires have learned over the years. Mega players, including hedge funds, corporate giants, and governments often try to muscle the markets and impose their wills only to find that true production and true end user consumption matter far more than their opinions as time goes on.
- When Spot, Futures, and Forward markets begin to de-link the spread that measures their different prices can go to apparently absurd levels. But there is always a method to the madness. That is what is occurring right now in Crude Oil. The paper players think they know the true value of Future Oil prices and bid prices up. The physical market players find there is little demand for Spot oil and offer prices down. And the arbitragers who normally link the two markets can no longer stop the widening because they have long ago run out of the ability to finance, store, and redeliver the barrels on sale. The illusion of riskless arbitrage profits quickly turns into real losses getting worse over time.
- Very high prices and very low prices both tend to encourage panic in many players. This can cause hoarding when prices are high and dishoarding when prices are low. This goes against everything taught in Economics 101, but it is part and parcel of all bubbles and their painful collapse. The hoarding in Crude Oil occurred as prices jumped higher and higher above $75 onward to $100 and $145. The dishoarding is occurring now as Spot prices slip into the low $30 range.
- Further aggravating the issue is the reality that NYMEX Crude Oil, the only Crude price familiar to many investors, no longer represents world crude oil. The NYMEX Crude Oil is a West Texas Intermediate light crude deliverable only in mid-continent USA (located in landlocked Cushing, Oklahoma). Although Arab nations produce 50 times more Crude of a type different than WTI Crude Oil a viable Futures market never developed for their type. Thus the producers and end users of world crude oil link their buying and selling to the NYMEX WTI contract simply because it is the most actively traded Crude Oil contract in the world. Just because a market is convenient does not mean it can properly hedge your needs.
- When fears of commodity inflation began in earnest several years ago some of the world’s biggest derivatives players, AIG and Goldman created indexes that allowed big investors to play the commodity inflation game. By July 2008 more than 300 billion dollars was indexed to commodities. The Energy sector is where they invest the largest portion of these index dollars. In order to imitate the price of Crude Oil the indexers buy the WTI NYMEX nearby future contract and roll it every month. A similar pattern is followed by USO, the leading Crude Oil ETF, which is attracting more and more speculative money every day now.
- The indexers don’t want physical Crude Oil they only want paper Crude Oil. Therefore, when the nearby future is about to come to delivery day no one wants to own it any more. This is one reason the paper market (NYMEX Futures) is seeing large distortions in its contango. The indexers “roll” their enormous positions each month by selling the nearest future month and buying the next future month. This can cause the contango to widen a lot and when the other players who anticipate this get out afterwards they can knock the spread back down quite a bit. The nearby future becomes a yoyo.
- While this is happening there is suddenly less need for physical Crude Oil as consumer consumption is anticipated to be collapsing. Speeding up the downward spiral in Spot Crude even faster is the dishoarding by huge investors. These very same investors may well have taken delivery last year as prices soared. They “knew” we had finally run out of oil and higher prices merely confirmed their fears and encouraged their greed. Likely candidates are governments, huge oil companies, corporate giants, Arab producers, and hedge funds. At this point no one now wants to admit being a buyer/hoarder at $75, $100, $125 or even $145 a barrel, but there was an enormous amount of buying going on. They are stuck in quicksand now with as much hope as the guys who bought the toxic CDO’s and CDO’s Squared of yesterday.
- When at last the oversupply and magical re-appearance of physical Crude begins to dwindle (as end users slowly work through it) the contango will slowly disappear and prices will firm. Meanwhile there will be an unknowable number of attempts to rally the oil market just because all these clever common investors “know” it is too cheap. One of the first things I was taught as a co"modity trainee many years ago – "It always gets worse before it gets better!”