Contango

The oil price plunge over the past several months has spooked the world’s biggest producer countries and energy companies.

But those traders who buy and sell physical barrels of oil, such as Vitol and Trafigura, have spotted a moneymaking opportunity. It’s all about “contango”.

What is contango?

When the current price of a commodity, such as oil, is lower than prices for delivery in the future, the market structure in industry jargon is known as “contango”. This means it is attractive for traders to buy oil now at cheaper rates, store it, either on land or at sea, and sell it in time to come for higher prices and make a big profit. They lock in the profits by buying physical oil and selling forward on the futures market.

What is driving it?

Relentless US production and sustained output from Opec has coincided with a global demand slowdown that has created a surplus in the oil market and put pressure on oil for near-term delivery. But prices for future delivery have proved to be more resilient, which is why the chart for forward prices looks like an upward sloping curve. Currently Brent crude, the international benchmark, for February delivery costs around $11 a barrel less than oil for delivery in 12 months, while West Texas Intermediate, the US crude market, stands close to $8 less.

How do you make money?

The futures curve, which plots futures prices against contracts that mature each month, has to be sufficiently steep that traders can pay for the cost of storing and insuring oil in tanks onshore or supertankers at sea — over the next year for example — and still make a profit. The steeper the curve (or the higher the price goes as maturity lengthens), the bigger the discount and the more attractive the storage trade is. But this contango play will last only as long as it makes sense financially. As soon as the structure flattens, the incentive to store will disappear, spurring traders to sell oil back into the market.

Who will profit most?

The winners are traders and integrated oil companies such as Shell, BP and Total with the access and ability to store large volumes. Vopak and other storage companies, as well as shipping companies such as Frontline, will also benefit.

When did this last happen?

During the “supercontango” of 2008-09, traders stored about 100m barrels at sea, according to shipbrokers. The difference between near-month prices and 12 months out was above $17 a barrel for Brent and more than $23 for WTI, spurring a flurry of cash and carry trades during the financial crisis. Shipbrokers say oil traders have so far booked supertankers to store between around 20m to 30m barrels.

What does this mean for prices?

The International Energy Agency has talked about oil “bumping up against capacity” in the first half of this year, particularly as European tanks get filled. However, analysts at Goldman Sachs have said a big increase in storage capacity in recent years means the oil market will be able to run a surplus for far longer than in previous cycles. This would help stop any storage blowouts and a collapse in near-term prices.

This is the first in a series online on commodities made easy.

For further reading:

Oil traders eye floating storage options FT.com

Record year for top five crude traders FT.com

Oil: The Big Drop FT.com