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  • Contango

    Posted by Dan from Madison on May 22nd, 2008 (All posts by )

    I learned a new word today, perusing this article that I found at Drudge (do I really need to give Drudge a hat tip?).

    I don’t know a lot about the futures markets, but the article states that some contracts have become more expensive than the spot price for oil, and that this is a rare event called a contango.  The article also states that this means that either the futures markets are unhinged, or that participants in this market are wagering that there will be a supply issue in the coming years.

    I would be interested to hear what our commenters and blogmates (who know a lot more about these types of things than myself) have to say about this.

     

    11 Responses to “Contango”

    1. Mrs. Davis Says:

      From the 1911 Britannica. There is nothing new under the sun.

    2. david foster Says:

      An even better commodities word is “backwardation,” which is the opposite of contango.

      Suggested alternative use of the words:

      “My goodness, Jimmy Joe, you’ve got the backwardation if you think I’m going to do the contango with you at the prom.”

    3. ElamBend Says:

      It must be the zeitgeist of the time, because I just learned the word a couple of days ago myself.

    4. Mitch Says:

      Been there, done that, priced the embedded swap in the Goldman-Sachs Oil Backwardation Note. It had to have been in the early 1990’s.

    5. Wade Says:

      From a recent Gartman newsletter:
      We are far more concerned, however, with what
      has happened and is continuing to happen within the term
      structure of the Brent and WTI crude futures markets, for
      both have gone contango across their entire term. WTI,
      from July ’08 on through December ’16, is now in
      contango, and although we suppose that that has
      happened at one point in the past (perhaps in the
      liquidation of MG trading many years ago), it is truly a rare
      circumstance. Note then that the 1st-to-5th futures spread
      for both WTI and Brent just keeps widening.

      There are two major problems with this shift in the term
      structure. Firstly, remember that Dr. Bernanke himself
      argued several months ago that the fact that the deferred
      futures prices for crude oil were lower as a reason for the
      Fed’s propensity to ease monetary policy. He argued that
      the futures told him that prices for crude were heading
      lower and that the Fed’s easier policies were warranted.
      We took him very strongly to task for this material
      misunderstanding of the term structure of the futures,
      noting that a backwardated market was the sign of future
      strength, not weakness. We argued that the work done by
      Professor Holbrook Working of the Stanford Food Institute
      many years ago regarding the grain futures market
      proved that markets in contango (that is, where the
      deferred futures are at a premium to the spot rate and to
      the nearer-by futures) tended to argue for lower prices as
      the underlying instrument “bids up” the price of storage.
      We argued further than Prof. Working proved that a
      market in backwardation (where the spot rate is at a
      premium to the nearest future, which is itself at a premium
      to the next future back, which is at a premium to the next
      and to the next and to the next) is a market that is strong
      and likely to rise. Backwardation, or a negative carrying
      cost, shows that demand is high and that the market
      wishes to price storage at a loss in order to draw
      inventories out into the market where they are needed.

      Dr. Bernanke and the others at the Fed have it now, and
      have had it in the past, entirely wrong regarding energy
      and the term structure of the futures. This we find wholly
      disconcerting. Having applauded Dr. Bernanke for his
      position regarding liquification of the banking system, we
      have to take him and the others at the Fed openly to task
      for this very ill advised position regarding oil prices,
      inflation, and Fed policy.

      That having been said, our friend, Phil Verlager, sent us a
      truly important note last evening that we wish, with his
      permission, to report in full here this morning. This is
      hugely important for those long or short of the deferred
      crude futures, and we urge them to take note. Noting the
      Hunt silver problem back in ’79, Dr. Verlager wrote:

      Dennis, There are clearly big problems in the
      dated crude contracts (Dec 11 to Dec 2016).
      One or more firms that sold the oil is trying to get
      out. They have a problem, though. The parties
      that are long do not want to exit. The situation is
      evident in the shift in open interest. From
      Monday to Tuesday the number of contracts
      outstanding for delivery from June 2013 to Dec
      16 declined while prices jumped $8/bbl. It is a
      classic squeeze.

      I would assert that this is not an oil market issue
      because the other indicator of long term oil
      prices, the BP Royalty Trust (BPT) did not
      increase with the 2016 crude.

      Someone has a big problem – and it could get
      much worse unless NYMEX and ICE order
      trading for liquidation….1979 redux.

      Phil has no position in crude. He is, as he says, and
      academic whose duty it is to observe and explain. We
      have been bringing this shift from backwardation to
      contango to everyone’s attention recently, arguing that
      this shift as prices move higher is unlike anything we’ve
      seen since the Hunt silver fiasco when silver moved from
      a contango to a massive backwardation, and since the
      days of MG Trading when crude moved from
      backwardation to contango… both moves in the term
      structures presaging massive changes in the flat price
      itself.

      Something is terribly amiss in the crude futures… terribly,
      terribly amiss. The elephants are coming out into the field,
      and we mice would do well to clear the decks and let
      these elephants fight with one another. We needn’t know
      the elephant’s names at this point. We will know them
      soon enough, but fore warned is fore armed!:

    6. Dan from Madison Says:

      An interesting article!

    7. Sella Turcica Says:

      This is all very interesting….too bad I don’t understand it. (It takes TOO much intelligence to understand CONTANGO….or: “It takes too..to..’tango.”)

      Anyhow, does anyone care to explain this in terms that a blockhead can understand?

      If futures are a lot higher than spot prices, why don’t I buy a big oil tank, fill it up with oil at $132 per barrel, contract to sell it in 2016 at $142 per barrel?, then sit back and wait for my GUARANTEED profit?

    8. Erik Says:

      Sella, have you priced a big oil tank recently? They not easy to find at your local grocer. Or the cost of keeping it compliant with local environmental laws or even getting the oil there and out? There are scenarios where prices could allow for risk free arbitrage opportunities like you outlined but they probably wouldn’t last long and price difference likely needs to be much more than $10 per barrel to cover all the costs (transaction, transportation, cost of carry, etc.).

    9. david foster Says:

      If you took the $132/bbl and instead of buying oil you invested it at 5%, this would generate $6.60/bbl in annual interest. Ignoring compounding, this gets you $52.80 in addition to your original investment, for a total of $184.80…much better than buying & holding the oil.

      Also, the physical oil investment is risk-free only if you buy insurance to protect yourself against fires, oil spills, etc.

    10. sol vason Says:

      If nearbys (including spots) are priced higher than far outs, it means (over the long run) prices are going down. If nearbys are priced higher than far outs, prices are rising. If you think about it, you will recognize the logic. Most people, especially news people, can’t understand this.

    11. SOL VASON Says:

      DISREGARD THE PREVIOUS – IT HAD A REALLY DUMB TYPO

      IT SHOULD READ AS FOLLOWS:
      If nearbys (including spots) are priced LOWER than far outs, it means (over the long run) prices are going down. If nearbys are priced HIGHER than far outs, prices are rising. If you think about it, you will recognize the logic. Most people, especially news people, can’t understand this.