The Enlightened Despot

I just found a new term to tuck away in my super-senior tranche of economic buzz-words: ’super contango’. The market for a non-perishable commodity is said to be in contango when futures for that commodity are trading for more than the current ‘now price’. (The reverse situation is called ‘backwardation’, which means that no matter what is going on in the market for a commodity, you can’t describe it with a straight face.) This is a fairly natural state of affairs, as commodities have a quality that is rare in finance: they actually exist in space and time. This means you have to keep them somewhere, and storage space costs money.

‘Super contango’ is a term currently popular to describe a situation in which futures are trading for more than the cost of storage and transfer; that is, I can sell you a promise to deliver $2000 worth of oil next month, buy that oil right now for $1000, spend $500 storing it and shipping it (generally to Cushing, Oklahoma, which, it turns out, is where crude oil deals go down), and walk away with $500 risk free. This, supposedly, is the situation we are in now.

You don’t have to be a hardline efficient markets theorist to think there is something wrong with this picture. Sometimes there is a free lunch, but it’s seldom well-advertised, and there’s never adequate parking. Kevin Drum mulls over a few possibilities:

So what’s going on? One possible explanation is that most of the easy storage is already full, so it’s not really possible to make a quick buck on this even if you want to. But even if that’s the case, there’s yet another option: oil producers can pump less oil now (essentially “storing” it in the ground) and then pump it out in July for delivery at the higher price. But apparently they’re not doing that. John Hempton figures there are two possible explanations: (1) they’re already pumping at full capacity, so they can’t promise to pump extra oil in July even if they want to, or (2) oil producers are so desperate for cash that they’re willing to take money now even if it’s way less than they could get for the same stuff six months from now.

#1 doesn’t seem to be true. So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now. Either that or else there’s an option #3 that’s not obvious.

Let’s back up a bit. Screw OPEC, why aren’t you making free money off this? There are a number of reasons, but most of them come down to the inconvenience of trading in real objects. As KJ points out, there may be a shortage in storage capacity, meaning that hanging on to oil is going to cost you a lot more than what economists think it should cost you when they claim we’re in a super contango. If you do find a place to store your oil, it’s going to be a big place - the storage and transport costs won’t work out unless you’re dealing with a whole lot of oil. A year or two ago, perhaps you could have raised a few hundred million in mortages on your mobile home, but credit is a lot harder to come by these days. And nothing is really risk free: if Somalia is inbetween Oklahoma and your oil vendor, you might have some explaining to do a month from now.

And these are just the problems an outsider such as myself can come up with, though I think they’re probably sufficient to explain why third-parties can’t profit off this situation. A lot of that doesn’t apply to oil-producers, however, which is what Drum wants to know about. Why can’t OPEC countries sell futures instead of oil, and sit on their output for a little while? Well, it turns out that the oil trade looks even worse if you know what you’re talking about:

Storing oil and selling Nymex futures forward means you have to physically have the capability to deliver the correct grade of crude - that being WTI - into Cushing when the contract expires. Cushing has a limited import capacity. As for the grade, you can’t just buy any type of crude and hold until delivery. West Texas Intermediate is a specific spec. While WTI doesn’t have to be sourced from West Texas, it does have to be blended accordingly to meet this grade. That spec and that spec alone is deliverable into Cushing. This complicates matters somewhat, especially for producers like Opec who would have to lock-in the corresponding blending components to assure Cushing delivery.

…

Essentially, because oil at Cushing can get bottlenecked - as oil can only flow in one direction to a specific number of refineries - it can get artificially bid down versus other grades in the prompt market. Given the fact that refining cracks are trading negative, chances of minimal take-up verus high delivery demand in the future (due to the contango) could make a bottleneck a real possibility. In that case, anyone selling oil WTI futures for delivery has to account for potential capacity problems at Cushing.

There’s a lot more there, and it’s worth reading if the logistical problems with oil trading are your thing, but that’s pretty much all you need to know. The product you can buy now and the product you are promising when you sell a futures contract aren’t necessarily quite the same thing, and it can be an expensive proposition converting the former into the latter. So maybe, despite what all the kids are saying, we aren’t dealing with a super contango after all; the costs of an arbitrage play are higher than they appear. Free lunch enthusiasts will have to look elsewhere.

Tags: contango, economics, precious precious oil

This entry was posted on Wednesday, January 14th, 2009 at 8:14 am and is filed under posts by Akhbar. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.