Oil Barges Coming Ashore

The number of oil barges floating full of crude has been decreasing according to the WSJ. The paper reported yesterday that “some analysts have seized on the contraction as evidence that world oil balances are tightening and the surplus that built up during the recession, when energy demand in industrialized countries plummeted, is eroding.”

Let’s break down the story and look at a few quotes:

The phenomenon of floating storage took off early last year. Oil on the spot market traded at a big discount to forward-dated contracts, in a condition known as contango. Traders took advantage of that by buying crude and putting it into storage on tankers for sale at a higher price at a future date. Profits from the trade more than covered the costs of storage.

Contango means a carry charge market – whereby successive futures contracts trade at a higher price from the previous month and so on, and so on.

Here’s what the Strip (Calendar 2010) looks like (click image to enlarge):

Crude Oil Calendar 2010

One oil analyst suggested that the “…contango has narrowed to around 40 cents a barrel, and ‘to cover your freight and other costs you need at least 90 cents.’”

Here are those calculations:

Carry Charges, as of the Close February 1

You can see that the right-most column contains what are called the carry charges. These differences are often referred also as the spreads. According to that analyst, they had been as wide as 90 cents and now they are much lower: they have narrowed.

Carry charge markets usually mean there is ample, current supply, and that the commodity in question can be stored generally speaking. That had been the case previously with crude oil as large traders who had access to cheap money (low/no interest financing) and cheap(er) tanker rates could arb out the difference for profit. The traders were hedged: they were long the physical and short the futures. No gambling and nothing reckless here for all my Huff Post fans!

Their storage and interest costs were calculable and much lower than what the spreads were in the futures market. Hence, traders long the crude could sell distant futures and wait for the prices to come down.

Now that the spreads have come in (narrowed), those easy profits aren’t there anymore, and hence the barges are coming into port delivering crude.

Lastly, in the article, J.P. Morgan is quoted as saying “prices could even go into backwardation at the end of the second quarter, where spot prices are higher than those in forward contracts.”

There’s another SAT word – backwardation. Look it up on Google (go to google.com and enter “define backwardation”) and tomorrow I’ll discuss how you would put on a spread trade in crude oil if you thought it would go from a carry-charge market to a market in backwardation.