Contango and Inventory: Clues to Oil’s Trend

By Brad Zigler

By now you’ve probably seen the headline about BP plc’s (NYSE: BP) massive new oil discovery in the Gulf of Mexico. Company mouthpieces are talking up the find as even bigger than the 3-billion-barrel Kaskida discovery made in 2006.

Even under the best of circumstances, it will be years before we’re able to count that oil as actual supply, but its impact on prices is inevitable. The oil market is a classic example of supply and demand being mediated through price.

Because most of our oil supply resides below ground (or under the ocean), oil prices historically reflect shortage. More often than not, the oil price curve is inverted, or “backwardated.” Backwardation occurs when futures are priced lower than the spot price. Since 1985, in fact, the average quarterly discount from the nearby NYMEX West Texas Intermediate [WTI] crude oil contract is 16 cents a barrel.

Why is this? Think of the ownership of oil reserves as granting a sort of call option to a producer. When futures are priced higher than spot prices—a condition called “contango”—a producer has the option of leaving oil in place, rather than bearing the costs of extraction and above-ground storage. If the majority of producers withhold oil, though, shortage is created, which in turn causes the spot or nearby delivery price to rise.

Thought of this way, you could say that weak backwardation is a necessary condition to stimulate current production.

Recently, though, the oil market’s been characterized by contango, rather than backwardation. The WTI crude oil market slipped into contango back in June 2008, just one month before the crescendo (and denouement) of the oil run-up played out.

In fact, the shape of the WTI futures curve is a fairly good proxy—and some might say, a good predictor—of our oil inventory. Contango coincides with large inventories, while inversion accompanies smaller supplies.

U.S. Domestic Oil Inventory Vs. WTI Futures Curve

U.S. Domestic Oil Inventory Vs. WTI Futures Curve

So does the present contango reflect an overabundance of crude? Historically speaking, yes. Since 1985, the domestic stockpile outside the Strategic Petroleum Reserve has averaged 323.6 million barrels. In May, supplies peaked at 375.3 million barrels. Some of that inventory has been worked off, but at last count in August, supplies were still above average at 343.4 million barrels.

Last year’s flip into backwardation accompanied the most dramatic plunge in crude oil prices in history. As crude oil prices swooned, contango grew spectacularly, until it peaked in January 2009. When nearby oil traded at the $35 level, there was enough of a spread between nearby and deferred deliveries to allow a 40% net return for a three-month cash-and-carry trade.

In a carry trade, a trader purchases cheap spot oil and, at the same time, sells a futures contract at a higher (contangoed) price, thus locking in a guaranteed sale. After paying for storage, financing and insurance, a trader could have made as much as $14 a barrel by capturing oil’s contango. Not surprisingly, oil inventories grew apace as carry trade operators vied for more and more storage capacity.

Market participants interpreted the rise in inventories as oversupply, which in turn pressured front-month futures downward. This contributed to the further widening of the contango.

Now, we’re witnessing the unwinding of the contango. At least that’s what oil bulls believe.

More than anything, the prospect of OPEC production cuts stabilized oil prices this year, bolstering crude’s price and narrowing the market’s contango. The spread between nearby and three-month distant futures is now less than $2 a barrel, and the carry trade is long-extinguished.

The question now is whether market participants will look upon a future drawdown in inventories as a reason to bid up nearby futures, further narrowing the contango.

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