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Sunday, March 15, 2015

Everybody Do the Contango

The oil situation can be understood in three easy pictures (courtesy of the U.S. Energy Information Administration). Got your dancing shoes on? Let's do the contango. (Bear with me.)

The first picture shows U.S. petroleum inventory trends. The shaded area represents the 5-year high/low bounds. The blue line shows how inventories have been tracking for the last 12 months.

For the week ended March 6, U.S. crude inventory was an unprecedented 448.9 million barrels (raw data here). Maximum physical U.S. storage capacity is 521 million barrels. Storage farms aren't actually at 86% of capacity, however (except on the East Coast of the U.S.), because around 30% of the oil counted by EIA as "inventory" is either still at the well, or in transit on ships or rail cars, or in pipelines. Still, much of the in-transit oil is in transit to storage facilities.

The retail price of gasoline (next chart) is heading up because this is the time of year when many refineries go idle for maintenance and/or changeover to summer-grade gasoline production. By the time refineries go back to full production, hotter weather will increase demand for gasoline. Thus, the price dip we saw in February (see blue dotted line) won't be repeated any time soon.

Crude oil prices (not shown) have continued to edge lower in recent weeks, even as inventories build. Hence, storage costs can be expected to become a more significant percentage of oil cost. As storage costs increase (which they're bound to, going forward), they'll add to the price of distant-month oil. (It makes sense, right? Someone has to pay the cost of storage, for oil you're not going to take immediate delivery of.) Therefore "out month" oil prices can be expected to firm up even as near month (and spot) prices drop. When this happens, the oil futures market is said to be in contango. The opposite of contango is when the out-month commodity sells for less than the near-month, a situation known as backwardation.

Here, we see that the WTI crude market has been in contango since December, and the trend is for more of the same. Refiners tend to purchase a mix of near and far-month oil. Near-month oil is going down in price (some say it will go below $40 soon), while far-month oil is staying the same or going higher. The net result is that refinery products are not likely to take a price dip in the next few months even if spot prices continue lower, because they're being averaged against higher-priced out-month oil.

Clear as mud, right?

You're welcome.

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