RETHINKING CONTANGO

Investing (speculating?) in oil has gone mainstream. The recent arrival of several exchange-traded products has opened up the commodity to the masses (iPath Goldman Sachs Crude Oil and U.S. Oil Fund.) There are also a growing number of ETFs and mutual funds that track broad commodity indices, which routinely have a significant portion of assets committed to oil. Beyond that, institutional investors in recent years have made strategic allocations to commodities in general and oil in particular. In sum, there’s a lot of new money pouring into oil.


The reason, of course, is stems from reading the newspapers and seeing that a bull market in energy has prevailed in recent years. Nothing spurs new investments like upward price spikes.
In years past, this web site has been among the promoters of oil as the next big thing. But the word is out, the money has poured in, Wall Street is launching products to exploit the trend, and so there’s reason to wonder if there’s a correction coming.
Before we discuss the future, let’s be clear on one thing: our view of energy as a long-term play remains intact. To summarize what we’ve written about many, many times in the past, the low-hanging fruit of oil discoveries are behind us, or so the data suggest. New discoveries of oil, when measured over the decades, have proven to be smaller and in more-remote locations. The prospects for discovery are further complicated by the geopolitical risk that hangs over the commodity. Iraq, to cite the obvious example, sits on massive amounts of untapped oil. Pumping it and shipping it is a problem, and probably will be for many years, for reasons that everyone presumably understands at this late date.
But while we’re bullish on energy for the long haul (10-20 years), the question is whether it makes sense to jump in now? Perhaps not. Even secular bull markets suffer setbacks. The peculiar nature of pricing oil in the futures markets provides the basis for our caution. To cut to the chase, the oil futures market remains in what’s known as contango, which means that oil futures maturing further out in time are priced higher than those that mature earlier.
For example, as we write this morning, the March 2007 oil contract on the New York Mercantile Exchange is priced at $57.81 a barrel; the March 2008 contract is priced at $63.10. Maintaining a constant exposure to oil, as per the standard operating procedure at most commodity-linked ETFs and mutual funds, requires selling maturing contracts and buying ones that mature further out. The problem is that when contango prevails, selling near-term contracts and buying those that mature down the road produces what’s called negative roll, otherwise known as a loss. Indeed, if you sold the March ’07 contract at $57.81 this morning and bought the March ’08 contract at $63.81, you’d be sitting on a 9% loss.
Now, we fully recognize that the loss can turn into a gain if oil prices generally rise enough to offset the negative roll. But expecting oil prices at this point to maintain the upward trend indefinitely may be asking for too much.
We’re hardly the only observer of the energy markets to make this warning. Indeed, an incisive analysis of the oil situation comes by way of the energy team in the London office of Sanford Bernstein & Co. In the firm’s newly published “Energy Investing: Beware the Ides of March,” the researchers note that “Forecasts of oil prices have a new variable to consider: passive investment.” They go on to explain, “Before 2002, you could project the commodity’s fate by estimating the outlook for spare capacity and inventories — but now you also need to figure out the timing and amount of funds flowing into commodity futures.”
Indeed, as the graph below illustrates (courtesy of the Bernstein report), the flow of funds into commodity funds has been robust in recent years.

In fact, the surge in passive index money flowing into commodity futures has “distorted the oil futures market, driving the curve into contango, causing it to diverge from fundamentals,” Bernstein & Co. writes. The question then is when the contango unwinds. The folks at Bernstein predict that it will unwind. Believing the rise of the contango to be driven by a speculative bubble, they predict that the bubble will burst, as most bubbles eventually do.
“Timing will depend on intricate relationships among Saudi Arabia’s production targets, the limits of physical storage and passive investors’ willingness to accommodate losses,” Bernstein admits. The researchers recognize that the demand for commodities as a strategic diversification tool remains strong, and so contango isn’t necessarily doomed to evaporate tomorrow. Once again we’re reminded of the old saw that the market can stay irrational longer than we can stay solvent.
Nonetheless, the risks of a price reversal are quite real, if not necessarily imminent, Bernstein warned. By the company’s reckoning, much will depend on Saudi Arabia’s willingness to cut production further. Even so, the natural order will eventually out. Such a cutback, the report concluded,

will only delay the inevitable because the country’s action would, in effect, create temporary underground storage. The longer commodity prices stay inflated, the greater the overbuild in capacity will be and the larger the eventual negative correction. A sharp and quick unwinding in the futures curve could force oil prices to $30-$35/bbl,
according to our analysis.

True, that’s one firm’s forecast, and so all the usual caveats apply. That said, if oil dropped to such a level, a lot of recent investors in commodity-linked index funds would take heavy losses, as would those who bought energy-related equities in the recent past. Then again, if oil dropped into the $30-$40 range, the opportunity to buy as a strategic long-term holding would be compelling. Perhaps, then, it’s time to raise one’s allocation to cash on the assumption that better values are coming.

One thought on “RETHINKING CONTANGO

  1. wcw

    Those Bernstein kids are smart, and I almost agree with this analysis. However, the problem with their ascription of contango to passive investment and speculation is right there on the chart: the amounts are measured in mere billions. Sure, a billion here and there and you’re talking about real money, but the world pumps 85m barrels a day. If Bernstein’s chart indicates we added ~$20B to demand annually in the last few years, then that added ~1m barrels to daily demand — significant, but hardly huge. Weather and global production growth swamp that 1% demand fluctuation.
    The hypothesis I’ve heard that I find more persuasive is that after the US invaded Iraq, the world once again woke up to political risk. The markets did what they are supposed to do, and expressed risk aversion in contango, which pays for storage. The world stored more crude, which serves the nifty economic goal of providing a bit more of a buffer should something really stupid happen.
    Whatever theory you like, I think the trade is much the same. I have been (mildly) short the energy complex lately, though I agree that the long-term play is for tightening supplies and higher prices. In the short term, I am betting against a cataclysm in the Gulf. For now, the world is well-supplied. After all, the Saudis don’t cut production in the teeth of undersupply any more.
    The time to buy back in will be when volumes are rising again.

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