Oil opportunities and the slippery slope of contango extraordinaire

Retarded Redux

Once, a friend from business school wrote in his capacity as a business journalist “It’s fascinating how retarded Syding is. He still hasn’t realized that…“. That was 20 years ago.

Well, here I go again, I just realized* there is this thing called contango…, and consequently I’ve had to update my view on oil.

*not really, see more below


 

Oil update – to keep or not to keep

This is a quick update on my thoughts on (brent) oil

It’s not a recommendation to buy or sell anything (see disclaimer page), it’s simply my thoughts on the issue of low oil prices potentially going (much) lower before exploding higher, and what that means for investments in oil futures and oil stocks.


 

Oil and Asperger’s

Back in August last year I wrote this article on brent oil and Asperger’s – about how I had profited from having both.

Today I’m long oil again, both a brent certificate/ETF (a Swedish instrument: Olja S)and two oil exploration companies (DNO and ShaMaran).

The case for oil is pretty easy and straight forward: the world is growing and we have reached peak cheap oil production. It will only become more and more difficult and expensive to find and extract oil, while the easily accessible oil reserves become depleted and go off-line one after the other. 

The case against oil relies mainly on solar energy and more effective use of energy, including storage (batteries). Well, that and the coming super recession.

I’m pretty sure renewables won’t be able to fill the oil supply/demand gap within the next five to ten years – at least not unless oil prices sky rocket again, thus making non-subsidized alternatives attractive enough. I also think a recession has been more than priced in. I consequently think oil prices will be much higher than today 18 months from now, and yet much higher 18 months after that.

10$ oil

In the short term however, there are a few snags, including 10$ oil:

  1. Easy money has fueled malinvestments in north American shale oil/gas production capacity. Nobody wants to be the first to fold, but some need to fold though in order to rebalance the oil market and support higher prices. The latter is taking longer than expected. Crashing oil junk bonds is, however, a good sign things are moving in the right direction.
  2. Crashing oil prices have forced Opec to pump even more oil than usual on order to keep their countries afloat. Russia, Saudiarabia, Kuwait, UAE and Iran simply refuse to agree on the needed production cuts. Instead they seem hell bent to keep at this chicken race at least long enough to crush the north American shale industry.
  3. Oversupply. The combined production of a pumped up Opec, Iran coming online and massive investments in shale production capacity have created a shortage of storage capacity. Once the industry runs out of storage (including in tankers and refined products) excess oil can and will be sold at just about any price.
    1. Yes, 10$ per barrel is conceivable (for a very short time) – if that is what’s needed to make anybody find use or (build) temporary storage for it, not to mention paying the cost to move the product.

Contango extraordinaire in the face of a storage crisis

The reason I am considering taking my oil profits to the sideline for a while is solely based on the risk of a storage crisis which could spark a panic sell off that in a single month can create a truly massive contango, wiping out 20%, 30%, 50% of the value of an oil ETF or certificate.

I have based my investments on Opec doing what they can to crush the shale industry.

I have been ready to sit through a bottom in oil prices caused by both a supply war and a simultaneous recession.

I have been quite calm, faced with a contango of  1-2% per month for the rest of the year, and a total of 20% until the end of 2017. No problemo.

oil futures

What I hadn’t really considered, until I listened to the MacroVoices podcast the other day, was the risk of literally overflowing oil storage facilities (check out some of the statistics here), and thus nobody willing to take delivery of oil at just about any price, while next month’s futures still trade at more or less reasonable prices. Even if current contango is limited to 1% per month, temporary spikes can kick that up to tens of per cent per month.

oil storage

picture from Art Berman via MacroVoices

I previously thought it would be quite easy to find alternative uses, or to build temporary storage facilities if you stood to make a dollar or two per barrel per month in arbitrage, but it seems it just isn’t that easy.

Hence, if a long oil ETF trade as of today is to become profitable, the current oversupply of 2 million barrels per day pretty soon has to come down to zero. It only takes a few per cent production cuts by, Russia, Saudiarabia, Kuwait and UAE to accomplish that. However, they just won’t, if Iran is increasing its supply at the same time, and definitely not if it means the US shale industry will survive.

If the cuts or shut-downs, shut-ins, don’t come soon enough, any product relying on rolling oil futures contracts over from month to month, could be more or less wiped out, and not recover sufficiently in the ensuing rally, due to too low a starting point.

Veering

So, it’s a chicken race, and I’m not entirely sure I want to be part of it anymore. The risk of suddenly losing even ‘just’ 10% in a single month’s contango simply is too much of a gamble for me.

I will keep my oil stocks, but I just might sell my oil certificates as early as this Monday.

If I were you, I would think long and hard about what kind of oil exposure I had and why.

With that I leave you, and encourage you to spread this article far and wide, to help others in their quest for making a quick buck in oil.

P.S. If you haven’t subscribed to my newsletter or read my eBook already, don’t hesitate to sign up. It’s free, spam free, easy to unsubscribe, and I hear it’s pretty entertaining as well as useful (sometimes)

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15 Comments

    • Thanks. By the end of this year I think. Wouldn’t hope for sooner, anyway

  1. Thanks for a great post. What about bear certificates based on rolling futures? As a bull certificate potentially will go to 0, will a bear x1 do 100% in day?

    • Not impossible. They would need to buy back the crashing front month, and get to sell the next contract at a much higher price, if contango exploded due to storage overflow.

      However, if storage doesn’t reach absolute full capacity, bear certs are a sure loser I think, since the price per barrel most likely will go up to 40-60 in 6-18 months.

      • As oil is now approaching 40, I can see a scenario where shorting oil could become a tasty r/r in my mind, especially if the theory of a possible sudden 100% jump is correct.

        The scenario would play out if the general sentiment on the stock market (whole economy) turns sharply negativ somewhere in the coming month ot so, and we get an even lower local minima than the last. Then I can see oil taking a final turn towards 20-25 dollars and stay there until the stock market (i.e expectations for the economy) starts a raising trend again.

        I should say that I am quite uninformed about the details of the oil market. It is…quite complex..

  2. So, do you still have Olja S or did you sell it due to the risk?

    Best regards

  3. What do you think of using the USL ETF 12 months oil futures to mitigate the risk/cost of contango if oil prices start falling sharply again and you want to place a long term bet?

    • Well, at least you know exactly how much you’re paying for your oil. A sudden and short-lived storage/contango crisis wouldn’t affect such an instrument (if it really is 100% 12M delivery, rolled forward every month)

      Should work.

      • Actually it seems to hold 12 different futures, one for each consecutive month. So I assume it would still be affected by a storage/contango crisis, even if less so than the USO or other 1M month rolling instruments.

        Any thoughts about whether the current rise in oil prices have given shale producers a better opportunity to hedge their prices and thereby bought themselves some extra time in production? Wouldn’t game theory then suggest that the likelihood of a storage crisis, and perhaps also of a prolonged one, increases?

  4. Mikael,

    Just wanted to say thanks for mentioning MacroVoices! I found your blog after a listener mentioned hearing about the show here. Great read! Thanks, and hope you continue to enjoy the show.

    All the best,
    Erik Townsend
    MacroVoices.com Podcast host

    • MacroVoices deserves all the mentions it can get. It’s important and as many people as possible should know about it.

      And from what you and I discussed over e-mail, even bigger and better things are planned.

    • Great call on the oil storage numbers, but the oil price just keeps ignoring gravity. I’ve sold my oil longs, but hold off from going short. Will look to buy on significantly lower prices… I hope.

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