Watch the Contango in Oil!
I just received a technical update on the oil market from our expert technician at Eidetic Research and the numbers are not looking good — a possible near-term collapse of the oil price under $30 with a probable range between $23.89 and $28.67. To see how this can happen, please read the article As recession saps demand, a world awash in oil. Pay particular attention to this at the end of the article:
Experts aren’t sure what will happen when all that oil finally comes ashore.
One fear is that with oil prices so low, companies will slash drilling and production, setting the world up for an energy crunch that would send prices soaring. The number of oil and gas rigs operating in the United States has fallen a staggering 39 percent since August.
Others say prices would plummet if companies forced millions of barrels onto the market at once.
“If everyone’s running for the exits at the same time, they’ll engineer a price collapse,” Flynn said.
Note that Mr. Flynn makes a mistake earlier in the article:
“It gets expensive to do this,” said Phil Flynn, an analyst at Alaron Trading Corp. “If you’re sitting on a bunch of oil and you’re stuck paying storage and insurance, and you can’t find a buyer, you may have to sell it at a discount just to get rid of it.”
Silveraxis readers already know that traders play the storage game going long spot oil and short futures so that they already have their profit locked in. As long as they can earn more in monthly contango than the monthly cost of storage, they will make essentially risk-free profits. There is, however, a small twist. The only way to close out the short futures position and actually get rid of the spot oil is to force delivery on the long futures counterparty. And this is where the risk for oil prices appears to lie. Such risk increases exponentially when contango starts to decrease below the cost of storage. From the article once again:
On the other hand, as storage units on land have filled up, the companies that own the tankers have profited. Tanker companies charge an average of $75,000 a day, three times as much as last summer, to hold crude, said Douglas Mavrinac, an analyst with Jefferies & Co.
In other words, storage is currently going for $1.10 per barrel per month! The math is: $75,000 x 30 days = $2.25 million / 2 million barrels per tanker = $1.125 per barrel per month.
With the above in mind, let’s take a look at contango in NYMEX crude. Closing prices for March 3:
| April ‘09 (CLJ09) | 41.65 |
| May ‘09 (CLK09) | 43.91 |
| June ‘09 (CLM09) | 45.03 |
| July ‘09 (CLN09) | 46.01 |
| August ‘09 (CLQ09) | 46.88 |
| September ‘09 (CLU09) | 47.71 |
| October ‘09 (CLV09) | 48.39 |
| November ‘09 (CLX09) | 49.01 |
| December ‘09 (CLZ09) | 49.63 |
| January ‘10 (CLF10) | 50.19 |
| February ‘10 (CLG10) | 50.74 |
| March ‘10 (CLH10) | 51.27 |
Do you see the problem here? Only the April to May contango is at least $1.10, from there it starts to shrink substantially. The contango for one year (April 2009 to March 2010) is under $10 yet it costs at least $13 to store oil for one year! The risk here is that the entire pricing structure may collapse during a capitulation in the oil market, sort of like a telescope. As contango collapses it is no longer profitable to store oil and many of the players will be forced to dump stored oil on the market whether there are buyers or not. Under such circumstances it is very possible that the technical target for crude in the $20s will be achieved.
Of greater concern for gold and silver investors and traders is the possible impact on metal prices. Even if you aren’t convinced that the dollar is headed for the 95 to 100 level on the dollar index (it just broke to new 3 year highs above 89.50), a drop in crude into the $20s is likely to create panic for commodity-themed investors who also happen to own quite a bit of gold and silver.
Many of you know that I am not fond of ratios such as the gold/silver ratio, the Dow/gold ratio, or the gold/oil ratio, but sometimes these “tools” are actually useful. One possibly valid use is to indicate extremes from which prices quickly revert. In the case of the gold/oil ratio, the upper extreme has historically been below 30. In other words, one ounce of gold can buy 30 barrels of crude oil at the price extreme. By contrast, as recently as last year, that ratio was under 7 at the other extreme. This doesn’t mean it cannot go above 30, only that it never has. Something never having happened does have a reasonable chance of never happening in the future and so we should be able to make a fair case that the gold/oil ratio should not go above 30 and is even less likely to stay above 30 should it be exceeded.
At an oil price of $25 in the mid-range of the technical analysis (which I hope to reprint in full for Metal Augmentor subscribers), a gold/oil ratio of 30 means that a gold price of $750 is at an extreme. Gold, however, is currently trading at $910, which means $25 oil would result in a gold/oil ratio of about 36. I believe reaching such a ratio is about as likely as the ratio staying around the recent peak at 25, which at $25 oil would mean a gold price of $625. Mind you, this would likely be a spike low and not a price that gold would find itself trading for long, but we are talking about a shakeout of such magnitude that we cannot rule out gold finding its final support near the long-term bull market uptrend currently around $580.
I see two main approaches to speculate on the possibility of these down moves in oil and gold. First is to buy put options in oil futures or any oil-related investments. More risky would be to short an oil ETF such as OIL or buy a short oil ETF such as the PowerShares DB Crude Oil Short ETN, symbol SZO. Going outright short risks the possibility that geopolitical events could overwhelm economic realities, driving oil and gold prices explosively higher. For this reason, I do not recommend outright shorts in either gold or oil. The second approach is one that I have been using since gold surmounted the $900 level at the end of January: buying put options in gold. I have been discussing and updating for Metal Augmentor subscribers the specific options and strike prices to consider and will be expanding the list of possible strategies shortly.
If the scenario unfolds as I’ve outlined here, most investors should just try to hold on and ride out the turbulence, which could be very violent but relatively shortlived. I expect gold to consolidate near the $800 level once the fireworks are over.
In terms of timing, my gut tells me things will play out in weeks but could drag out as long as the end of May or into June. The overall odds remain low but will increase if the contango in oil shrinks from current levels. Thus, watch the contango in oil!!! If the one year contango in oil drops to $6 or so, the consequences are going to be unpleasant! In comparison, probably very little else will matter in the weeks ahead.
What I don’t understand is why the producers have not been curtailing their production. It can’t be that hard to turn off the pump that pulls the oil out of the ground.
They might have to sack some people but better than sending themselves bankrupt.
It IS that hard to curtail production! For one, lower price times lower production equals even bigger losses. Nobody is going to be selfless and first to slow down production so all oil producers will benefit. That was the idea behind the OPEC oil cartel, and even that barely works.
I see your reasoning. Oh well, at least that means the price of petrol might not go up here in Australia, despite the pathetic state of the AUD.
Tom, any thoughts about the direction of the AUD?
The last time commodities tanked so did the AUD. I don’t think the RBA has done much about the quality of the assets on its balance sheet since then.
It’s my belief that it was only the ’swap’ facility with the Fed that allowed the RBA to redeem its liability and arrest the AUD’s slide.
You could be right, AUD appears headed for .50 although it could catch a break at .60.
Justin: Don’t feel too bad for the AUD… Here in Kiwiland things are pretty grim. While I appreciate the NZD value of my Silver and Gold has not declined, I was looking forward to adding to my positions at much better prices than what we have been having.
The whole “demand-has-collapsed” story is bogus.
Demand was about 85.8 million barrels per day in 2008. According to the IEA demand in 2009 will drop by 450,000 barrels per day to 85
million. ONLY a 0.5% drop!
Since supply has dropped much more than demand will, the current price of oil is irrational. Sorry silverax, but I don’t buy your story on “world is awash in oil”.
On the contrary, the price of oil is manipulated by - who else - the criminals at the NYMEX and JPM.
yeah, the numbers simply don’t add up,
either we are facing massive drop in fuel use in 2009 or look no further than lindsey williams scenario
The “world is awash in oil” story is not mine, it came from the press. Raw demand figures are not reliable for several reasons. One, they do not take into account geography, treating each barrel of oil as if were fungible (available for delivery anywhere in the world). This is just not the case — only a minor portion of the world oil production is actually priced on international markets like NYMEX, most is subject to over the counter arrangements. Two, no heed is given to inventory stockpiling and other factors that impact supply and demand. Although not included in the IEA demand figures, the U.S. and other countries were adding aggressively to their strategic petroleum reserves during the past few years. Now, not so much. The NYMEX and JPM are what I would call scapegoats.
Tom,
If there is a big sell-off in the front-month contract, most likely this will widen the contango - making it profitable again to store oil.
Buying puts every time you think there could be a sell-off is a losing strategy in the long run. In my opinion you are better off selling some out of the money covered calls and not stressing out so much about the ups and downs.
We should not assume that conditions in the oil market will remain the same once inventory is being released back into the market. The large spot month contango was occurring as storage was being increased, now that storage is very tight and little additional capacity is available the game is likely to change. If demand does not pick up and if it is no longer profitable to store oil, prices will come down across the board because some of the biggest oil speculators on the long side will exit the market. It doesn’t matter if it is profitable to store oil if there is no storage space. Assuming that some space will become available and then get filled up again requires one to conclude that tight storage is a stable condition. I assure you it is not.
I don’t buy puts every time I think there is a sell-off coming, I buy puts when the risk-reward is greatly skewed in my favor. That was the case with copper last summer and I believe it may be the case with oil and gold in the weeks and months ahead. I don’t have to be right even 10% of the time to make money if I structure the trade appropriately. Perhaps I’m biased coming off a 5000% return late last year.
I would agree with you that selling covered calls is probably a better strategy most of the time and I have been and will be looking for some good opportunities to do that.
Good points. I actually did end up buying some USO puts today, although I still think there is a decent chance that energy has already bottomed.
Agreed there is a decent chance, but this issue of the storage coming back on the market immediately is a very serious overhang that is not getting a lot of attention.
Light sweet crude in BACKWARDATION!!!
Spot = $44.00
April = $41.65
May = $43.91
This is not correct, the spot price appears to be delayed or perhaps it is the previous day’s close.
Selected oil stocks look like a great contrarian buy at the moment, although the P&F charts show further potential falls of 10-30%, so watch your timing!
Many oil stocks are not sensitive to crude oil prices because their main business is refining and gasoline sales, so you need to be sure which oil stocks you are looking at.
What does crude being in backwardation mean? I am trying to learn about backwardation in general so an overall view would be greatly appreciated.
Thank you,
Jeff
Crude in backwardation means there is more demand for physical delivery than there is physical supply at the delivery point. West Texas Inter. crude (the main NYMEX contract) was in backwardation several times in 2008 at contract expiration because there were more bidders for delivery at Cushing, Oklahoma than there was oil to sell.
Looks like I got old data on my screen; spot still lower than other contracts. Sorry for that.
Anyhow, the curve does seem to flatten. Contango is very minimal at the moment. Especially from June until the end of the year.
> silveraxis says:
> the dollar index just broke to new 3 year highs above 89.50
Actually, it didn’t
Serge, Care to explain why you don’t think so? I am looking at the cash US dollar index which hit a high of 89.624 overnight (Wednesday for you in Russia). The last time the dollar traded at this level was April 2006.
Well, possibly just a spike: on a small Kitco’s graph, it touches ~89.50 a few times, but then drops down to 88.70. I don’t reject a possibility of USD going higher to 92-94 (or even higher), but this will cause sever deflation pressure on already weakened economy and the stock market. So I just guess PPT would do everything they can (i.e. expanding credit and money supply) to avoid a new deflationary crash.
BTW, Gary Tanashian considers also an alternative scenario for USD:
http://biiwii.blogspot.com/2009/03/scenario-2-illustrated.html
On a personal note - I currently reside in CA, not in Russia
I don’t think there would be much psychological downside to the USD trading in the 90s although breaking 100 would be a major event. The alternative scenario you reference for the USD is certainly plausible. Sorry for assuming you are in Russia — by CA do you mean California or Canada?
Just read an article from Reuters talking of a significant drop in US oil inventories?
The “significant drop” is a few hundred thousand barrels. We can start talking about oil returning to stable supply/demand balance once that drop reaches 10-20 million barrels.
can the crude go in to backwardation mode in the very short term … ???
Anything is possible but I don’t see how this will happen given there is little storage capacity for crude and therefore the spot demand would have to come from end users. Typically end users, however, don’t buy large quantities of oil in the spot month right around when the NYMEX futures expire. They only did that when demand was extremely tight.
Saudi hikes April crude prices to all buyers
DUBAI, March 4 (Reuters) - Saudi Arabia raised its official selling prices to all its customers for its crude in April, state oil firm Saudi Aramco said on Wednesday.
The kingdom raised the price of Arab Light to U.S. customers by 90 cents to West Texas Intermediate (WTI) plus $1.90 a barrel.
It raised the Arab Light price for customers in the Far East by 65 cents to the Oman/Dubai average plus 90 cents a barrel.
.90 increase while 1.10 month storage is = to 25 days storage
using the gold/oil gauge
could this cushion a gold drop ?
by .90 x 30 = $27
The amazing thing to me is that Saudi Arabia and other countries still sell oil by reference to the WTI price. This is no doubt being done so as to remain “good friends” with the West.
Or should I be calling it Rooters?
Chinese yuan set to replace dollar
Make of it what you will, although it is not rocket science!
http://new.asianews.it/index.php?l=en&art=14131&size=A
Hmmmm, will “King Dollar” be finally dethroned and relegated to “Slave” status by the Chinese Dragon ?We shall see.
I think it would be a great boon to the world economy if the yuan was to start floating. the 2 biggest imbalances in the world economy today are first and foremost a flood of overvalued dollars and secondly a flood of cheap chinese goods. Once they start selling in Yuan it’s value would have to rise and thus start correcting these two gross imbalances. Conditions would improve for the world economy to stabilize and start to grow. Knowing the Chinese this would be a slow transition enabling the rest of the world to start weaning off the dollar. In the long run this will be good for the U.S. whose leaders would have to stop their unlimited spending while some manufacturing could return to the U.S.
I agree it is good for balancing world trade eventually but I don’t see the yuan becoming a reserve currency or literally replacing the dollar. China might seem like a great competitive powerhouse but in many ways it is even more messed up than the U.S. with much larger asset allocation problems and a host of extremely challenging social, political and economic issues to contend with in the next couple of decades. You know propaganda is involved when an “article” mentions that the dollar is losing its value despite the fact it is trading at 3 year highs. Those 8 other countries with which China is conducting this “experiment” are likely to devalue their currencies as much if not more than the dollar is set to fall.
FOLKS….its GRADE SCHOOL MATH.
The SOVIET UNION COLLAPSED while pumping 9 MILLION BARRELS of OIL A DAY. The only thing that saved RUSSIA was due to the fact the KREMLIN and KGB only allowed the Citizens to use 2-3 million barrels a day in consumption. Russia could PULL itself out of the COLLAPSE as they had a SURPLUS of OIL to sell.
The UNITED STATES is quite similar to that old ROSS PEROT saying, “A GREAT SUCKING SOUND.” The USA pumps about 7 million barrels of oil a day and IMPORTS over 12 MILLION. If you passed 3 grade MATH…you will realize there is a NEGATIVE somewhere in the RESULT.
WHen the DUST SETTLES and Countries go back to trading SURPLUS GOODS….the UNITED STATES will have a BIG PHAT ZERO. That means it will have to SURVIVE on half to two-thirds less of what it is currently consuming. NASCAR will have to go to burning CORN ETHANOL or something the RED NECKS in the country can BREW UP.
We can play MATH all day long….but in the END….THE GREAT WHITE ENEMA will destroy all MYTHS of the FINANCIAL DERIVATIVES. At some point in time people will have to actually do WORK FOR A LIVING and leave behind the OFFICE where tapping on a computer could make oneself 6 figures.
Grade school math doesn’t always work to solve a given problem. The Soviet Union collapsed because it had an economic and political system that resulted in terrible productivity. Nine million barrels of oil per day is nothing for a country with over 200 million people (it is about $100 billion per year or less than $500 per capita). It is a little known fact that today Russians actually consume much more oil per unit of GDP than Americans. Realistically the U.S. can cut 50% of its oil consumption given conditions as severe as the 70s oil shocks. Given enough energy desperation to overwhelm environmental concerns, the U.S. has virtually unlimited energy sources in coal, oil shale and nuclear know-how. The fact that these options exist, even though they may be many years from implementation, is precisely why the U.S. will not be cut off from cheap oil by the major producers. Doing so would merely hasten the necessary transition that will need to take place at some point in the future regardless.
Here are a few ideas on oil and oil speculation
Major Point A
1. FACT - oil well depletion is real! It exists now, in the past and the future. All oil wells go from discovery, rising production, plateauing production, declining production and extinction. At early stages of decline, (near the peak) the decline rate is typically about 8 percent per year. As the well nears extinction, the decline rate often drops to a low number and allows the well to produce at lower levels longer.
2. FACT - oil is a non-renewable resource
Putting the two facts together leads to Peak Oil. All of the evidence that I have sifted through from the many experts in the field, IEA and the EIA suggests that Peak Oil occurred between 2005 and 2008. It is the likely culprit of $147/bbl oil and its effects are now being ‘masked’ by the current economic Depression. The overall decline rate worldwide production is in the range of 1 to 5 percent.
Virtually, ALL major oil fields are now in decline. Here are a few examples.
Cantarell Mexico - an estimated 8% annual decline
North Sea - 5% annual decline since 2000
Alaska - 2 million bbls per day in 1986 - now less than 500,000 bbls per day.
Russian oil fields are now in a slow decline
Kuwaiti and Saudi fields are likely in a 2% decline.
Bottom Line - A speculator that is SHORT oil is fighting against the iron law of depletion. They may win in the short time period, but MUST lose in the end.
Major Point B
Precise Inventory data is impossible. These are at best estimates with huge uncertainties. The require people to go out and measure the amount of oil in thousands of individual tanks every week and submit the data in a timely fashion. This is a near impossible job. As a result, the number can swing several million bbls per day just by random chance. Despite the shortcomings, the market expects that these numbers represent a high level of precision.
If prices are high, inventories are presumed low, everyone is convinced that prices will go higher, a higher inventory number generated by random chance will ‘devastate’ the market, and let the astute trader make some money.
Right now prices are low, inventories are presumed high and everyone is convinced that prices will go lower because demand is weak. A random inventory draw will send prices higher. An inventory build at these levels is expected and will likely have only a minimal impact.
Bottom Line: let randomness help you.
Major Point C
Even if the inventory data is accurate and precise. It really isn’t very large. It is only about 30 million bbls higher than the lows of last year. This is hardly huge. In fact, ten years ago, such inventories were considered normal or even lean. Also, as a matter of perspective, 30 million bbls is only about 1.5 days worth of consumption for the USA!
Bottom Line Keep the total inventory is perspective.
Major Point D
Because of huge depletion of oil production in the USA and North Sea since 1995, OPEC’s market share has grown. This makes them a more formidable cartel. Just because they cheated on each other and flooded the market 20 years ago with oil doesn’t mean they will do it again. Assuming past behavior will prevail (even after 20+ years) is a big, big, big mistake. The situation is much different and so are the people involved.
Bottom Line: Extrapolation over time is dangerous
Major Point E Arbitrage is still alive and well
Just based on chart action oil seems to have found a reasonable bottom in the $35 to $45 range. Brent crude is higher than WTI which is weird since WTI is a higher grade of oil - sweeter and lighter. Low prices for WTI will discourage imports. Why ship to the USA when you can sell abroad for a higher price?
Major Point F
China and India’s oil consumption hasn’t really dropped like the media reports. Instead only the rate increase in consumption has slowed. This is an important distinction.
Major Point G
Right now oil is highly correlated with the stock market in the USA. There are really no fundamental reasons for oil to plunge. However, it has dropped and may drop some more. Only a fool fights the tape!!
I trade in and out of DXO.
Many of these are valid points (especially for the medium to long term) but none of them address the NEAR-TERM fact that oil storage at the WTI delivery point at Cushing Oklahoma is at capacity and the cost of incremental storage is getting extremely high. If contango collapses because a portion of speculators pull out of the oil market (much of the positions are in the outer, not spot, months) it will no longer be profitable to store oil and much of the overhang could come to the spot market all at once. This is an “if” not a “when” because there are many factors involved in the oil market but the risk is very real and not at all remote. As with gold, oil has not really capitulated, which is quite amazing considering it has already fallen more than 75%. Finally, my “theory” lines up with the technical analysis by Eidetic which calls for a possible violent final drop in oil prices in days or weeks. I have provided this analysis to Metal Augmentor subscribers so they can assess its veracity for themselves.
The stone age did not end because we ran out of stones. Likewise the modern age will not end because of peak oil.
Something will replace oil well before the peak.
I still maintain, the worst is over for oil and it will begin to rise again this spring and into the summer. I doubt we will see huge increases, however.
I think the Cushing inventories are declining and the large spreads between WTI and Brent will discourage imports. Domestic production is not really large and is made up of tens of thousands of small wells which will be / have been shut-in, or production stored on-site.
Bear markets often end in a violent capitulation. This is a signal to the asute that the worst in over and it is time to get back into the market. However, given the increasing sophistication of the market, this signal may not occur in oil for this bear market. Sometimes commodity markets make quiet lows that go unrecognized.
Also, because of the massive numbers of oil ETFs out there, the COT data is now useless in my opinion. You can no longer tell what the volatile ‘traders and speculators’ are doing. These funds may destroy the capitualation signal.
All this said, I would not pile into any oil stocks and only trade the ETF/ETNs lightly until I see a clear new uptrend.
Regarding the comment…
“The stone age did not end because we ran out of stones. Likewise the modern age will not end because of peak oil.
Something will replace oil well before the peak.”
There is no real data regarding man’s transition out the the stone age. Since stone is ubiquious, I doubt that it was a resource scarcity issue.
The transition from the Bronze to the Iron age is perhaps more instructive. It was a resource scarcity issue to some extent. It wasn’t the bronze which was in short supply, but the lack of timber in regions around the foundries.
Near the end of the Bronze age, both iron and bronze were available, and bronze was considered more desirable. Iron quickly rusted, became brittle and looked bad. Bronze did not. (Steel was not yet invented). Essentially, firewood became scarce enough to ‘end’ the Bronze age. This was a time of turbulence.
Whether we find a substitute for oil or not, the time following Peak Oil will be a turbulent one as supplies dwindle. We are currently poorly prepared to transition from oil, and will likely remain so until well after the problem becomes obvious to all.
Oil contango is collapsing in the context of rising price.
One year contango is under $6.
Month to month less than a buck.
A long-term chart showing contango/backwardation levels vs spot would be interesting. Any suggestions?
Lindsey Williams on Energy
http://www.youtube.com/watch?v=ZKCyCYz_aHY&feature=related
http://www.investmentrarities.com/ SilverX are you still out there. Did you listen to David Morgan’s comments on my previous post, any thoughts. Also I know your not a big Ted Bultler supporter, well let me rephrase that. You do not support his short position theory on the comex. However his recent commentary shows very compelling evidence of criminal manipulation going on in the comex market, according to commodity laws. While the CFTC stands idle and does nothing. This trading activity goes against all free market principles, I believe the data clearly shows that.