Contango: 2012 Edition

Regular readers may remember that every year at this time I do some basic arithmetic regarding contango.

As a refresher, contango is the discount you can get on a non-perishable commodity by virtue of your willingness to accept delivery at once, or (stated inversely) the extra payment you make if you want the seller to hold it for you for some interim.

One would naturally expect this discount to be closely related to the costs of storage space. After all, if I buy crude today and tell you to deliver it six months from now, you have to keep it somewhere during the interval, and pay the maintenance on the storage facilities. If I take delivery now but I don't use it over the six months, then the cost of storage falls on me.

So: a year ago I simply measured the per-barrel price for March (2011) delivery (which was $89.58) against that for August delivery ($94.49) and extrapolated that into an annual rate. The five month delay in delivery cost the buyer $4.91 at that time, which extrapolated into an annual figure would have been $11.82, which is roughly 12.5% the price of a barrel.

Checking the figures a year later ... the price of a barrel was $98.33 for March 2012 delivery last time last weekend. Never mind the question of why that has gone up. I'm focusing on just one piece of the puzzle now. The price for August delivery was $99.62. That's a difference of only $1.29 for storage for five months. This annualizes to $3.10, which is roughly 3.25 % the price of a barrel.

So contango has taken a sharp fall over the last year. Why is contango on the increase?  Don't know.  Three theories come to mind initially. First, this could be a reflection of a stronger dollar. Crude oil is priced in dollars, the dollar has picked up value against other currencies as the 'cleanest shirt left in a pile of dirty laundry' of late. A year ago, for example, a dollar could buy you .625 GBP. These days, it can buy you .642 GBP.  Perhaps, then, there's a deflationary effect built into contango.

Second, this could be the response to an increase in storage capacity. After all, back when contango was 12.5% of the price of a barrel, there was a great incentive to bring on line new facilities to hold the stuff.

Third, this could be a reaction by speculators to a presumed coming decline in the value of oil -- the long-feared second dip in a double-dip recession.

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!

Three brief items

First, Dan Rather.

His lawsuit against CBS for wrongful termination will likely go forward -- it has survived a motion to dismiss. I can't help but be happy about this, as I think the proceedings may help unearth testimony and documents that will in turn prove useful for the historians of the future as they struggle with this period in the history of the United States.

Rather, you will remember, narrated a report on the CBS evening news that said that George W. Bush shirked his duties while in the National Guard.

The authenticity of the documents came under attack, and CBS apologized for the report, expelling Rather from the anchor chair.

Rather maintains that the report was, in essence though not in every particular, accurate. He also says that he was made a scapegoat because the parent corporation of CBS, Viacom, was seeking regulatory favors from the Bush administration and had to hide the whole AWOL issue under the nearest rug.

CBS' lawyers made a motion to dismiss. No definitive decision has yet issued from the bench on that motion, but the judge has indicated he is inclined to let the matter proceed to discovery, that there is "enough in the complaint" to do so. Good for him.

Second, Crude Oil Prices.

How low will they go? And is their recent decline a good sign or a bad one? Just wondering.

You'll likely all remember that when crude prices were bumping up against $100 a barrel in the final days of 2007 that fact was covered extensively in all news media. This is natural enough: my attention tends to focus on my car's odometer as the zeros line up!

With odometers, the numbers only move in one direction. With prices, the general tendency is toward an inflation of the currency (given the fiat nature of money since the demise of the gold standard) and thus toward higher prices, but there's some non-odometer like downward movement too.

And that's what we've had. On Nymex, the spot price of a barrel of oil is now barely above $90. Is this good news or bad? Good if it amounts to a lifting of a drag upon the economy. Bad if it is symptom a symptom of a slowing-down already underway. After all, if there's going to be a lot less industrial activity in coming months, there's going to be a reduction in the demand for energy in all its forms, and the decline may simply reflect that.

Third, Springfield, Mass.

Springfield appears to have gotten away with something. For the background, go here.

Springfield has apparently persuaded Merrill Lynch that it has a case that somebody at Merrill tricked somebody in Springfield's city government into signing on to some highly speculative investments. Accordingly, Merrill has agreed to by the securities at issue back from the city at the same price at which it sold them.

This is quite a bath Merrill is taking. Those securities have lost 90% of their value since the sale, last spring, now being revoked.

Merrill has also agreed to pay outside legal fees incurred by the Springfield Finance Control Board.

This stinks. Has anybody associated with any institution ever heard the phrase "moral hazard"?

So of my three items for today, I find the first cheery, the second ambiguous, and the third depressing. A balanced portfolio of news items!

Mezrich's latest

Rigged, the latest book by Ben Mezrich, describes the world of oil-futures trading.

It may not sound like the most natural subject for book by a general-interest publisher like William Morrow -- given the bald statement of the setting above, one might have expected Wiley & Sons to publish this.

But Mezrich became famous with a book about card counting in casinos. For him, the oil futures exchange, especially the New York Mercantile Exchange, or NYMEX, where much of this book is set, is as exciting as any casino in Vegas, and his goal is to make us feel the same.

I've written about Ben Mezrich in this blog before, in particular about his book about American arbitrageurs in east Asia, The Ugly Americans. As I said at the time, the claims of the book to be non-fiction are a bit unsettling. Mezrich changes more than merely the names of his characters, and at some point "protecting one's sources" and such becomes, simply, fictionalization.

I have the same difficulty with this one. Consider the subtitle of Rigged. It's "The True Story of an Ivy League Kid who Changed the World of Oil, from Wall Street to Dubai." The insistence upon the "true story" part is my hang-up here.

Consider, now, the following passage, the opening paragraph of chapter 3.

"There was something uniquely soothing about the whir of helicopter blades. The rhythmic, circular disruption of air, each and every turn apply calculable lift, allowing a thing that should not fly instead to float, like a magic carpet in a child's coloring book -- a carpet made of steel and Plaxiglas and in this case solid gold. Even as the rhythm slowed and the floating, five-ton, bug-eyed carpet came to a gentle rest on the jutting ivory-white helipad, the whirring blades continued their soulful cadence, the long steel appendages cutting slower and slower arcs until all that was left was the beat of the thing itself, the soothing rhythm of a thing that should not be -- but, indeed, was."

Clearly, the author is taking us inside the mind of one of his characters here. The character in question isn't the "ivy league kid" the book is written about. Rather, its another young man, a Cambridge University schooled heir to Arabic nobility, Khaled Abdul-Aziz. Khaled's desire to do something grand for the future of Dubai makes him in time an important ally to the central character's desire to modernize and expand NYMEX. And it's Khaled who is supposedly thinking these thoughts about helicopters and their soothing blades.

As a piece of descriptive prose in a novel, I'd consider the above over-wrought. And the "carpet made of steel" bit makes the helicopter sound like a train they call the City of New Orleans. Still, since we're reading a work of non-fiction, we can infer that at some point Khaled confided in Mezrich about his feelings regarding helicopters, right?

Wrong. At this point, we have to flip back to the author's note, where we find the following lovely disclaimer. "Characters such as Gallo and Khaled are composites and are not meant to portray particular people."

I'll ignore Gallo for this post. Khaled is a composite? Non-fiction is, I think, consistent with the use of composites to simplify an overly complex narrative when the author is (as here) upfront about that. But ... composites in that sense don't have a "stream of consciousness." If we portray a composite as thinking of the "slower and slower arcs" of a helicopter on the landing pad as "soothing" then we've crossed the line and created a fictional character.

The South Park character "Towlie" did this sort of "non-fiction" writing once. He had an excuse. He was smoking pot at the time.