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Saturday, December 27, 2008

Light Crude Oil: More thoughts on futures, rollover, contango, index funds

Just some notes to myself. If you don't understand this, just ignore it.

In the present environment in Nymex light crude oil, contango poses a real practical problem for the long term investor who chose to be exposed to Light Crude using futures (e.g. Nymex).

Take this Dec 19 as example, when current month futures price crashed to below $34 at expiry.

The "long term investors" who were long Jan 2009 contract on Dec 19 who left the rollover process to the last minute suffers huge losses in 2 ways.

First, on Dec 19, the sale price at closing just prior to expiry is terribly poor, as everyone else wanted to do the same thing and sell. Consequently, these "long term investors" got hit badly, when everyone else wanted out.

Second, on the same day, if this "long term investor" wants to roll-over into subsequent month contract, the price is much higher due to contango. For example, whilst Jan 2009 contract might sell at $33, Feb 2009 contract could only be bought at say $42.

In this sense, contango is a real practical problem if the "long term investor" didn't consider his rollover carefully, because he has suffered the price fall to $33, and by reentering at $42, since this price has now fallen to $35, he has suffered another price fall again, almost equivalent to $33 falling by another 16% or more.

In other words, an investor who doesn't pay careful attention to timing his rollover contract could suffer consistent deteriorating loss, simply due to contango and poor rollover, if light crude price doesn't rise after he rolls-over, but stays flat. For example, imagine that light crude stays flat at $35 for 6 months, but the market is in contango. So, every month, when he rolls-over at $42, he suffers $7 loss per month by month end because it dips to $35. After 6 months this way, he would definitely be wiped out. (in fact, for futures, just a single $7 loss in a month is often enough to wipe out some of the poorly capitalized, over-leveraged, over-bet players, let alone 6 consecutive months of $7 loss).

Interestingly, the current month contract also happens to be the most popular month contract.

The long only crude oil index funds which invests in such futures contracts could become risky in this sense, if their index mandate is to be invested in current month contracts, and if they mechanically rollover at each month end at expiry date. They would certainly fall into the category of "long" (as opposed to short) investor (since index fund, i.e. indefinitely long term) in crude oil by mandate, and some of these use a combination of cash and futures to maintain an equivalent net crude oil exposure. Those who does this will financially suffer from mechanical rollover at expiry date due to contango.

I believe we have actually seen this phenomena happening on Dec 19. Certain light crude oil long index fund price continues to fall from Dec 19 to Dec 26, even though futures current month contract appears higher (from $33 on Dec 19, to $37 on Dec 26).

Let's see whether similar effects will be observed next month.

For future reference.

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