Crude oil and contango

There are worlds of stuff I don't know, so bear with me. The price of a barrel of crude oil on the New York Mercantile Exchange at the end of trading Thursday was $43.26. It is heading back up from its lows in the 30s.

On Friday, a barrel for March delivery sold at the close for $46.47.

Could it be that the cold winter is pushing up demand? No. Markets look ahead. We're at the worst of the winter in the northern hemisphere, so you would have expected that meteorology would be fully discounted by now. Indeed, you might see the markets looking ahead to spring, which would indicate a lowering of demand for crude.

The market could be looking ahead in another sense, to the greater quantity of driving that generally comes with spring. But that would seem to be countervailed by the recession.

Or ... the market could be telling us that things are turning up. The optimistic reading of the price increase is that it results from speculative demand increase which in turn results from signs (seen by the speculators, if not by you and me) that the economy is about to turn around.

But let's not rush to that conclusion. Think first about contango, a word that appears to have nothing to do with Argentine dancing. [Yes, I had to get that one out of the way].

Contango, the word seems to be derived from "contingent," is the discount you can often get on a commodity by virtue of your willingness to accept delivery at once. Suppose I have a barrel of oil and I want to sell it. You want to buy ... but you want me to deliver it to your place of business six months from now. Why would you have to pay more?

Because the oil isn't doing me any good in the meantime! It is taking up space and there are maintenance costs associated with storage. So I make you pay for that. What you pay for my storage (or, looking at it the other way around, the discount you get for accepting the oil immediately) is your contango. This elemental reason for contango is called "cost of carry."

I've heard from no place worth mentioning that a good guess for costs-of-carry historically is about 14% a year. So if contango is greater or less than 14% there should be explanations other than "where the heck do I put the stuff."

The above barrel price, $46.47, is as I said for March delivery. That is as immediate a delivery as Nymex listings will get you. Going out further, a barrel for August 2009 delivery goes for $53.81.The present difference in price between March delivery and August delivery then is $7.34. That would work out to $17.64 annual. As a percentage of $46.47? About 38%. That's one mean contango.

I might like to suggest that this confirms our earlier suggestion: that the market is signalling a recovery soon. There is such high contango NOT because the costs of carry have gone up dramatically but because speculators would rather have crude oil six months from now than now. And they'd rather have in six months from now because they are getting signals that people are going to be driving more, the wheels of industry are going to be turning ... good times are back.

But then ... I'm still uncomfortable. After all, forgetting speculation, the simple cost-of-carry sort of contango might have increased to 38% annually. Why not? Maybe all the easy storage spaces are all used up, and it takes extra expense to bring new storage space on line (marginalism, anyone?) and THAT is leading to a sizeable discount for anyone who will take the stuff out of the marketers' hands quickly.

All this is making my head hurt. Enough!