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Contango Dooms Reason for Strategic Oil Release

Chart In Focus
June 24, 2011

This week's news about the coordinated release of strategic oil reserves by several countries helped to push crude oil futures prices down sharply.  One interesting side effect of the selling was that the sympathetic selling in other commodities helped to spark the selloff in gold and silver prices that I wrote about 2 weeks ago, according to the 1980 bubble top's price pattern analog

While this release of oil from the Strategic Petroleum Reserve (SPR) has helped to push down the near month prices of oil futures, it has not had much of any effect at all on the out month contract prices.  As an example, one week ago the August 2011 oil futures contract was at $93.29/barrel, and it closed on June 24 at $91.23, down 2.2%.  But the June 2012 contract fell just 1.1% from a week ago.  All of the expiration months have been falling since a peak in early June, but the out months were not much affected by the SPR release this week.  That difference in response is interesting.

Back in February, I talked about how a huge contango had developed in crude oil futures prices, with the near month contract well below the distant months' prices.  February's big contango got resolved when the near month prices shot higher in response to unrest in Egypt, Libya, etc. 

Just recently, contango completely disappeared, as the near month prices were at exactly the same prices as those 11 months out, which is something we have not seen since 2008.  That lack of contango correctly said that a topping condition was at hand for oil prices.

But now with the SPR release producing a sharp drop in near month oil prices, a big contango is getting reestablished, and that condition is likely to prevent the goals of the SPR release from being achieved.  The reason is that big contangos create an incentive to take away short term supply, because a trader can make money buying up the product on the spot market and storing it for future sale at a higher price.  And that trader can even lock in the price at which he will sell the oil in the future by selling a contract for future delivery. 

The ability to use such storage arbitrage is limited by the costs of storage.  And so there has to be a big enough difference between the near month and far month prices to pay for the transaction and storage costs.  Back in early 2009, there were stories about traders renting supertankers at $50,000 a day or more, just to use as floating storage tanks to take advantage of the big price spread.  If the price spread is big enough, the rental of the tankers, or of storage tanks, can be more than made up for, provided that risk-free interest rates are kept low. 

Interestingly, if the powers that be really wanted to drive down crude oil prices in a meaningful way, there is a more effective way: just raise short term interest rates.  While the first derivative thinking is that higher short term rates hurt the economy by raising the cost of capital, second derivative thinking would show that higher rates would take away the profit potential from storing oil.  That would push down spot prices without having to raid the nation's emergency supply. 

Tom McClellan
Editor, The McClellan Market Report

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