How Markets Influence Oil Prices

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You would have read here, at oil-price.net, that oil producers and refineries use the Brent Crude Index and the West Texas Intermediate Index (WTI) to settle contract prices for oil delivery. The real-world contract price for oil can vary widely, despite whatever the current price of WTI and Brent Crude is at the time of contract negotiation.

The basic mechanism for settling a price in any market is the principle of supply and demand. If people want more of a commodity than suppliers have available, then the price goes up; if there is more of a commodity available than people want to buy, then the price goes down. Delivery times, delivery costs, storage availability, the weather, the economy, market "sentiment," and the availability of money and credit can all influence the price of oil.

The Futures Market

The Brent Crude and WTI indices both display the average price for oil reported by the big buyers and sellers of crude oil. This is the "spot" price, which means the cash price for a barrel of oil where the transfer of ownership occurs now. The futures market deals with a forward price. When a buyer strikes a futures contract for crude oil with a producer, the contract contains an agreement that the sale will occur at a specified point in the future and at a specified price. The buyer does not pay then and there – that would be the spot price reported by Brent or the WTI. Instead, the contract is meant to be paid in 3 months time, or 6 months time, or one year ahead, for example.

So a buyer and a seller may sign a contract for the immediate transfer of ownership and an immediate payment, but with delayed delivery – that would be dealt with on a commodities exchange. If the contract specifies delayed transfer of ownership and a synchronized payment at a future date, that contract would be dealt with on the futures market. Given that the only difference between the spot price and the forward price is the date of transfer of ownership and payment, then you would expect that the two prices should be fairly well coordinated. They usually are, but at the moment, the two markets are out of synch. This situation presents opportunities for speculators and can artificially raise immediate demand for any commodity or service, which will increase the price.

Contango and Backwardation

You would expect that the forward price of oil should be a prediction of what the spot price will be on a certain date in the future. You should be able to look at the 3 months forward price today and expect that experts are saying "this is what the spot price of crude oil will be if you check again in three month's time." However, this is not always the case. Sometimes, the forward price of a futures contract can be higher than the expected future spot price as well as the current spot price. This situation is called "contango."

The opposite of contango is called "backwardation." This is where the forward price is lower than the expected spot price. Both contango and backwardation send signals to technical analysts and generate instructions to buy or sell contracts that have nothing to do with real-world demand or supply. In normal conditions, most futures contracts are in backwardation, because the buyer would otherwise have no incentive to commit to a future purchase.

In effect, the futures contract offers the buyer a discount on the expected spot price and the contract's existence provides the supplier a guaranteed sale, which is worth the loss of a small part of future income. A contract will go into contango if the commodity to be provided is expected to become difficult to source around the date of the contract's maturity. Thus, the buyer is prepared to pay a little more in order to secure future supplies. The predicted spot price is calculated on analysts' expectations of the scarcity or abundance of a commodity on the contract's date of maturity. Therefore, contango is a rare occurrence and happens when a market suddenly turns due to an unforeseen event, creating shortages that experts didn't expect at the time the contract was negotiated. Those shortages could be caused by a Civil War, disrupting production, a shortage of tankers to transport the oil, or an unforeseen rise in the cost of storage, due to overproduction.

Example

Contango occurs where a producer creates an agreement with a buyer so that the sale will happen in three months time at a price of $45 per barrel. The current (spot) price is at $50 per barrel, but both the buyer and the seller were advised that the price of oil will fall in the next three months. After completing the contract, the buyer then receives a call from a broker, who offers to buy the contract for an equivalent price of $55 per barrel, so the futures contract is now worth more than the price per barrel written into the contract.

If a broker calls the buyer and says "hey, buddy, I'll take that contract off your hands, but I'm only going to $42 per barrel, and you pay me the shortfall now," then the contract is in backwardation. As the delivery date of a contract draws closer, the value of the contract will draw closer to the expected spot price on the date of maturity. Thus, the broker that bought the contract in contango will lose money. Contango and backwardation generally occur when producers and suppliers suddenly find themselves in desperate need of immediate cash and are prepared to take a loss on their obligations in exchange for immediate payment.

You may hear that oil market is currently in contango. However, when oil market analysts use that term, they use a slightly different definition to that used for contracts.

Market Contango

People are only likely to take a loss on their futures contracts if they are desperate, have been duped, or have made the wrong guess on the future price. Markets, as a whole, don't generally all make the wrong decision at the same time – in order to buy at a discount, someone else has to be selling at a loss. When market reporters write that the oil price is in contango at the moment they use the simpler contango definition of when the forward price is higher than the spot price. On contracts, the price the contract sells for has to be higher than the expected spot price in order to be defined as being in contango.

Profiting from Contango

Oil price speculators make money from contango simply by buying crude oil for delivery now and then writing out a futures contract to a buyer. This is the classic way merchants of non-perishable goods make money – buy when the market is low, wait for demand to increase and then sell at a higher price.

You may realize that, as a small investor, you are not in a very good position to keep thousands of dollars of oil. The contango speculators rarely hold onto the oil they buy themselves. Instead, they contract out the transport and storage to specialist companies. However, as with any market speculation, even the big players can get caught out.

Complications

People and companies that make money from contango are simply exploiting the differences between the prices on two markets – the crude oil market and the futures market. However, in order to make sure to profit from the transaction, those speculators need to research the conditions in the many other markets that impact on the price of oil.

The price of storage facilities and specialist oil transport rises and falls with supply and demand. A speculator has to be careful that these two intermediate costs do not wipe out the entire margin he expects to make by holding oil. The cost of insuring the oil both while in storage and in transit should also be considered. Traders also tend to hedge most of their risk and that costs a percentage as well.

The contango play is a form of financing because it enables one person to avoid storage costs while another takes on that risk and expense for a profit. The speculator would only go into a crude oil arbitrage transaction if he could make more money than he could on some other form of speculation. This is an opportunity cost. What other profits is the trader losing out on by tying up his money in oil storage for a period of time?

Wider Price Implications

Traders in oil can profit from contango speculation without even getting involved in the arbitrage transaction themselves. In 2005 and 2006, contango in the crude oil market caused speculators to buy up oil tankers and use them as storage facilities. A large proportion of the supply in the market was mopped up by people buying simply to hold. The use of tankers to hold the oil meant the traders took care of their storage and transport needs with one facility. Analysts estimate that the 2005 contago fad added between $10 and $20 to the price of oil.

Analysis

The 2005 contango buy-up was the result of attempts to profit from panic in the market. Analysts expected an impending shortage looking forward from a market where supply and demand were in equilibrium. The sudden rush by speculators to buy up physical crude oil made the prediction of shortages a self-fulfilling prophecy, and in fact heightened shortages, thus increase the price of crude oil.

Today's oil market is oversupplied and is predicted to continue in oversupply for some time to come, so market contango does not make sense as a difference between what oil costs now and what it will cost in the future. Tip sheets and financial reporters have noticed the current contango - or shall we say super-contango - and are now reminding their readers of what happened in 2005. However, contango is unlikely to cause a rise in the price of crude oil this time around.

The 2005 panic was caused by a prediction of imminent oil shortages. Those conditions do not apply today. Oil refiners are adjusting their output at the moment because they are coming out of winter and adjusting to summer. Demand is lower in summer than in winter, so demand for oil is actually about to drop. The current oversupply will get worse.

Brokers like a rising market and may be attempting to recreate the conditions of 2005 by encouraging speculators to soak up the excess oil on the market and store it for a while. Once the upward momentum in the market begins, everyone will profit by selling off their stored oil. However, as the future market will still be over supplied, speculators will still have to keep buying and storing vast quantities of oil in order to create a shortage.

Real Contango Profits

Unfortunately, for any syndicate of multi-billionaires out there, there just isn't enough storage available to divert enough oil from the market to get the indexes rising again. The US oil industry's main storage facility at Cushing, Oklahoma is almost at full capacity, thanks to US refineries stopping production for maintenance in February.

The difference between the spot price and the forward price of crude oil is time. Buying and holding oil passes time and bridges between the spot and forward price. However, the futures market does not point to the real source of profits to be made from contango. The forward price is the spot price plus the cost of storage. Storage is becoming in short supply, and therefore, is getting more expensive. In order to extract the profits from contango you need to buy oil storage facilities.

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