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Saturday, December 27, 2008

Light Crude Oil - Is this a normal Contango Spread?

As at Dec 26, light crude oil futures market is said to be "in contango", meaning, the price of crude is higher in future months than spot month, with an upward sloping forward curve.

The opposite is known as "backwardation" (downward sloping forward curve), which I am guessing happened with a rather strong effect about 6 months ago, when current month crude oil peaked at around $147.

Now, being "in contango" does NOT automatically mean that current month price will necessarily rise. This is because, "rational pricing" suggests that there is a "cost of carry" to hold the commodity today for future delivery. Such costs include storage fees (including security and insurance), as well as interest foregone on monies tied up. So, it is quite normal for light crude futures contract to be in contango since it is a non-perishable commodity which can be stored for years if necessary (unlike perishable commodities like pork bellies, etc.).

However, the question in my mind right now is is the size of current spreads rationale?

For example, from the above table, Feb 2009, 2010, 2011 crude selling at $37.80, $52.96 and $60.30 respectively, giving a 12 month spread of $15 (2009-2010) and $7 (2010-2011). Is this a rationale spread? Why is $15 so much larger than $7? And is this sustainable and exploitable?

Perhaps not for an average Malaysian retailer like me. However, what about from the eyes of a professional arbitrageur / hedge fund manager? Since, if he can, then, prices may converge over time, as fear reduces and they start smelling opportunities. And if they can move prices, then, can I take advantage of this expected move?

The size of the spread seems large. For example, the $15 spread represents nearly 40% return on $37.80 Feb 2008 contract. In other words, an arbitrageur can buy Feb 2009 contract and sell Feb 2010 contract (with zero NET crude oil exposure), and receives 40% margin (=52.96 / 37.80 - 1) to cover the cost of carry. Whereas doing this for another year (2010 to 2011) only provides 14% margin (= 60.3/52.96 - 1). If we ass-u-me the normal annual cost of carry is 14% (a big ASS-U-ME), then, there is another 26% marginal difference (= 40% - 14%) in the nearer term. And if we think that risk-free interest rates will rise in 2 years time, then, this difference appears even more irrational.

However, the size of the spread (40% margin) has actually declined since a week ago. Recall Dec 19, 2008 when Nymex Jan 2009 contract expired with a closing price of below $34. The same price on Jan 2010 contract on Dec 19, 2008 is $55, with nearly $21 spread, and far larger than $15 spread observed today. However, Dec 19 was a once-off event in that it was a Nymex light crude expiry day, and obviously, someone who was long that day just simply didn't want to take delivery and was forced to sell, regardless of price, which created an excellent opportunity for the other side to arbitrage/profit. And probably no similar opportunity for an average retailer like me to profit from this expiry event.

Where am I going with this?

Well, just rambling ... I also came across this article quite by accident - http://oiltradersblog.blogspot.com/2008/12/contango-scares-uso-and-dbo-investors.html - and found myself wondering if I agree with the writer, in particular, the first paragraph statement that says "This little monster (contango) is scaring investors off simple passive funds". After thinking a little about it, my feeling is that this writer probably confuses cause with symptom, since if contango is a normal phenomena, then, the observed contango is merely a symptom or the result of prices falling more on the spot month, rather than the cause. So, the fall in prices of these passive funds are probably due to something else, rather than contango itself. Using contango to explain price falling is rather like saying "the price falls because it fell" or "the price falls because it did not rise", which is a rhetorical tautology - it is true, but is redundant, and does not really convey any useful information. However, the overall article, and certainly the blog is interesting and thought provoking, even if one may not necessarily agree with everything that's written there.

For future reference.

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