Oil in contango

Royal Dutch Shell (RDS) and British Petroleum (BP) have been acting on these interesting developments of price differentials.

These European oil majors are buying oil at the spot market (or hoarding their own produced oil) and are selling short the back months.

These companies are able to meet their delivery obligations easily.

Recently Citigroup's commodities proprietary-trading desk, Phibro, also began playing this contango game. Two weeks ago, Phibro rented an Ice Transporter hoarding oil which is thrifting in front of the Scottish coastline.

This supertanker has a storage capacity of one million barrels. Phibro bought at the spot market so called North Sea Forties Grade Oil and sold subsequently January Brent futures which were priced 30% higher than the front month futures contract.

Gross profit is the difference between the price received from the back month contract and the spot price paid.

Of course other costs, such as storage, insurance and financing have to be subtracted.

These cost reduce of course the gross profit. Nevertheless a lot of money can be made, on the provision that large positions have to be taken. At a certain moment, this spread will diminish as more traders are playing the same arbitrage game. The market participants must have deep pockets and staying power, since positions can turn sour in the meantime.

Spot price variance

Patience is also very important. The front months do not move one-at-one with the spot prices.

Earlier last week, the expiring February-contract dropped a severe 7%, while the May-contract dropped 'just' 4.6%. Thus pushing the position (long Febs/Short Mays) under water. On the long run however prices tend to move towards each other.

It is tempting to simulate this game by buying nearby contracts and selling further dated futures. For instance during the previous expiration, the January futures dropped, while the February contracts did not drop at all, or very little.

The reason could be that traders being long January contracts, did not want to take delivery, closed out (sold) these positions and bought February contracts.

Shipment companies which let these vessels are likely to profit from this game regardless. These companies can be compared with the producers of gold-finding/producing equipment during the Gold Rush. An increasing amount of vessels will anchor in front of the coasts, until this game is not profitable anymore.

Seasoned investors could for instance invest (with a certain degree of risk and within a time frame of one or two years) in shipment companies like Frontline, Teekay Corporation of subsidiary Teekay Tankers and Mitsui OSK Lines.

Speculators could apply a more aggressive strategy with futures, options or other derivates, as long as traders are aware of the risks.