Notes on the present oil price contango

The dominant story in energy markets — and the economy as a whole — has been the sustained slide of oil prices for the past year. Energy prices are closely monitored because they can have wide-ranging impacts beyond the oil and gas sector. Any industry that relies on electricity, heating, or transportation has an embedded energy cost, and oil price fluctuations affect the cost of doing business. The same logic holds true for the everyday individual and the personal economic decisions that we all make regarding energy expenditures for fuel and utilities.

Oil prices matter, and this column will try to give them some context. In particular, I will discuss the difference between present prices and expected future prices, and how that can impact financial decision-making. And that word in the title, “contango”? Contango is when the expected, future price for a commodity is higher than the present spot price.

The two leading indexes for global oil prices are West Texas Intermediate (WTI) and Brent, named for the spot markets where oil is bought and sold. At the end of the day on March 22nd, those indexes were $45.72 and $55.32, respectively, for a single barrel of crude oil. A year ago, the respective prices on those indexes were $89.94 and $101.92.

Six-month and twelve-month price histories for West Texas Intermediate crude courtesy of the NASDAQ index.

There are two main culprits for the decline in oil prices. On the supply side, there has been a remarkable surge in production from US oil producers, due to advances in technology and in unconventional fields. On the demand side, worldwide economic growth, particularly in China, was lower than expected. Lower economic growth translates to lower demand for oil products. Essentially, there is a lot more oil available in the market than is wanted by consumers. Traditionally, when there is a supply glut in the oil market, OPEC responds by cutting production in order to keep prices at a profitable level. However, it seems that OPEC is willing to let prices continue to fall, as low oil prices hurt their competitors: the US oil producers that are driving the supply glut.

As stated before, the oil market is in a state of contango. Spot prices are cheap today, and commodity traders fully expect prices to be much higher in the future, even if they are not sure when exactly that future will arrive. If you have a barrel of WTI crude today, would you rather sell it at $45 today, or maybe $55 or $60 a couple months from now? If you have the storage capacity and don’t need the money today, isn’t it worth the wait?

A select few trading firms have made that exact decision and enjoyed huge profits in the second half of 2014. At oil terminals in Cushing, Oklahoma and Houston, Texas, astute oil traders have purchased hundreds of millions of barrels of extra storage capacity with the intention of sitting out the bear market. This storage behavior can lead to a bit of a negative feedback.

Crude storage inventory volumes at the Cushing, Oklahoma oil terminal. Storage capacity is at an all-time high. Courtesy of eia.gov/todayinenergy.

Every barrel of oil being stored is a barrel that is not reaching the market, so if there is more oil in storage, there is less oil in the “available” supply. This withholding of crude from market helps to prevent prices from falling even further. But there is still a ceiling on how much oil can be stored. Based on EIA statistics, the US utilized 48% of total oil storage capacity a year ago. Today, current estimates have that figure at 63%. There is a little supply-and-demand story there too. As available storage decreases, storage capacity will become more expensive. Despite low crude prices and declining rig counts, US producers continue to pump oil at high levels.

Here’s to finding somewhere to put all of that sweet, sweet crude.