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Last contango in oil optimism

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Published: December 4 2008 20:20 | Last updated: December 4 2008 20:20

In the energy market, the price of crude oil is not the only value that is falling.

The difference between the price of oil for immediate delivery and the one-year forward contract – a key indicator – on Thursday widened to -$13.50 per barrel, the largest spread since US oil futures started trading 25 years ago.

The magnitude of the spread, known as a contango because future prices are higher than spot prices, is shocking the industry as it reflects the current extraordinarily weak state of demand.

But it appears that other factors are also contributing to this record spread.

In normal circumstances, the price gap will narrow slowly as traders arbitrage physical barrels – buying spot crude oil and putting it into storage while, at the same time, selling a forward contract to lock in a profit.

As such trades support spot prices (traders buying oil for immediate delivery) and depress forward prices (traders selling futures), the spread should narrow until it hits a level where the cost of storage and capital is larger than the contango.

However, the energy market is not in normal circumstances.

The credit crunch has distorted the arbitrage process as market participants – from traditional physical traders and oil companies to private equity groups and hedge funds – cannot secure loans to finance oil storage.

Michael Wittner, head of oil research at Société Générale in London, says the ability of the small players in the physical market to secure credit is an issue contributing to the contango widening.

Edward Morse, chief economist at LCM Commodities, a New York-based brokerage, says the financial crisis means that it requires a larger contango than was the case historically to encourage market participants to put oil in storage.

“The credit crunch looms very large,” Mr Morse says.

The abrupt drop in oil prices is also making the process of raising finance more difficult.

Traditionally, stored oil was pledged as a guarantee – collateral – for a loan. However, banks are nervous about taking oil as guarantee after witnessing crude prices collapsing to $45 a barrel from July’s record of $147.27.

Where market participants are able to raise finance, it is at a much higher cost, traders say.

Finance is not the only constraint, according to Amanda Lee, an oil analyst at Deutsche Bank in Hong Kong, who points to costlier storage capacity.

“We believe that, when the oil market is oversupplied, incremental or marginal storage tends to come from floating storage [vessels], which is costlier than fixed storage,” she said.

Ms Lee estimates inland storage costs at about 40-70 cents a barrel with floating storage costs at up to $1.60 per barrel.

In spite of these difficulties, there are signs that storage is filling up, both inland and floating, in response to the record contango.

Nauman Barakat, at Macquarie in New York, says companies have an incentive to build inventories before the end of the year to minimise their US tax liabilities.

Oil inventories in Cushing, Oklahoma, the delivery point for West Texas Intermediate, have increased 58 per cent in the past three months to 22.9m barrels and traders say more is on the way.

Oil stockpiles at other key locations – the Caribbean, Rotterdam in the Netherlands, Ashkelon in Israel and Singapore – are also rising, analysts say.

Companies such as Shell and BP and big traders such as US-based Koch are also starting to store oil in tankers, with shipping brokers reporting the hire of several supertankers as floating storage in the past few days.


Lex: Hopec – Dec-01

In depth: Oil – Nov-30

Lex: Russia and Opec – Nov-27

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