Oil Contango Continues, Inflates Stockpiles

Robert Gibbons and David Sheppard, Reuters

A big premium for long-dated U.S. crude futures may linger until the economy recovers, causing oil stockpiles to swell further by making it more profitable for traders to buy oil for storage.

Oil prices for prompt delivery have risen nearly 40 percent since mid-February to around $50 a barrel, but remain more than $25 cheaper than contracts for delivery five years down the road, a market structure called "contango".

The contango has already encouraged dealers to raise U.S. oil stocks to their highest levels since 1993 and to lease dozens of supertankers to store oil at sea.

And the far end of the futures' curve is likely to remain elevated by optimism that oil demand will rebound when the global economy recovers.

"The strength in the out months and years is based on the belief that economic recovery will eventually arrive," said Tom Pawlicki, analyst at MF Global in Chicago.

A contango structure can be self-sustaining. It encourages dealers to store oil for sale at a later date, and the resulting higher inventories keep downward pressure on prices at the front of the curve. Contango can also raise the price differentials for spot crude, as traders buy oil to store.

Analysts said that as long as the month-to-month discount for prompt crude runs larger than the cost of storage, traders will be encouraged to stow oil away.

"The contango structure in the market is still pricing a level where oil is going into storage," said Olivier Jakob at Petromatrix in Switzerland.

THE CURVE STEEPENS AGAIN

The spread between front-month and second-month oil on the New York Mercantile Exchange hit a six-week high over $2.50 a barrel this week, far beyond the cost of storage, bolstering buying interest in the physical crude market.

Analysts estimate onshore storage costs average about 70 cents per barrel per month, with offshore storage in tankers nearly double that.

The contango in U.S. crude futures has been firmly in place since October. Front-month barrels were priced almost $8.00 below second-month contracts in mid-January, helping push oil stocks at Cushing, Oklahoma - the delivery point for NYMEX crude - to a record 34.9 million barrels by early February.

Cushing stocks were down 14 percent through April 3, according to data released on Wednesday. as the contango has abated since mid-January.

But at $2.50, the contango may again be steep enough to push Cushing stocks higher, several oil traders said.

"The front switch has stretched out toward $2.50 per barrel while the one year portion of the curve has expanded to around $13 per barrel," said Jim Ritterbusch, of Ritterbusch and Associates in Galena, Illinois. "This widening reflects a combination of both burdensome crude supplies and improved expectations for oil demand later this year and next."

The outlook is a boon for oil traders such as Koch Supply and Trading, Vitol and Royal Dutch Shell (RDSa.L), which are among the companies that have made the biggest storage bets.

Frontline (FRO.OL), the largest oil tanker shipping company, estimated on March 20 there were about 40 very large crude carriers, each able to hold 2 million barrels, storing oil offshore.

CONTANGO CAPS A RALLY

A steepening contango structure signals that OPEC supply cuts of 4.2 million barrels a day since last September have not yet put much of a dent in a global oil glut. That's because oil demand is also falling, for the first time since 1983.

The back end of the curve, meanwhile, is being supported by expectations that international measures to combat the global recession may eventually work, or that OPEC's production cuts since last September will eventually reduce import levels.

Some analysts are also arguing non-OPEC production is set to fall in 2009 and 2010 due to lower prices and tighter credit, further choking off supplies.

"The rally since mid-February has been a contango rally with the impetus coming from the back-end of the curve -- investors are looking at the future and seeing less OPEC supply starting to tighten the market in later months, and further out on the curve, they're pricing in the marginal cost of production around $70 a barrel," said Petromatrix' Jakob.

"(But) as long as we keep this contango structure, it's going to be hard for crude to rally above $55 a barrel."

- Copyright 2009, Reuters. All rights reserved.

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