Cheap Oil and Expensive Oil Tankers: This Is Contango

During the last half of 2008, as the global economy ground to a halt, the price of oil fell from an all-time high of $145 a barrel to less than $40. A lot of people lost a lot of money. Just as in the stock market, though, the oil crash presented a chance to buy crude cheaper than it had been in years and might ever be again. If you had a place to store that cheap oil, you could make a lot of money when prices rebounded.

Thus was born the booming demand for oil tankers, or any other place to stash low-cost crude.

By January 2009, with prices still hovering around $50 a barrel, there were some 90 million barrels of crude in floating storage. The futures markets had entered something traders call contango, a fancy commodities term for the expectation that prices will rise in the future. When the oil market is in contango, a contract to buy crude a month from now costs more than the current price. The further into the future you go, the more expensive it gets. All an oil trader with storage space has to do is sell a futures contract to lock in that higher price a few months down the road and then just sit on it. Some call that hedging. Others call it free money.

With the economy slowly healing, it was a matter of time before commodity prices returned to normal. For most of 2009 the current price of oil was consistently several dollars below the future price. Not only did the demand for oil tankers surge, but land-based storage hubs gushed with oil. In Cushing, Okla., the largest oil hub in the U.S., the amount of oil in storage  more than tripled in four years—from 15 million barrels in September 2008 to 47 million by summer 2012.

The amount of oil stored at Cushing, Okla., tripled from 2009 to 2012

As oil prices steadily rose in recent years, contango went away. Given the chaos in so many oil-producing parts of the world (Libya, Iraq, Russia), the oil markets have been remarkably calm. A strange balance has been struck: The world has plenty of oil at the moment, thanks in part to the U.S. shale boom, yet there is strife everywhere. When Islamic State, the militant Sunni Muslim rebel force, stormed out of Syria and took control of a large chunk of northern Iraq in early June, prices spiked at first, then fell once it became apparent that most of Iraq’s oil wells were safe.

OIl prices have been steadily falling since mid-June

Oil prices are now in the midst of a two-month slide, one of the longest and steepest drops since the recession ended. As Europe’s economy has grown closer to recession and those of emerging markets such as Brazil have fizzled, demand has slipped. Supply remains strong, particularly as U.S. oil production continues to climb at a record pace.

For the past week, Brent crude, the international benchmark for Atlantic basin crude, has traded below $100 a barrel. That’s put it back in contango. In the futures market, the price of oil for delivery in March 2015 is $101. That’s not as big a difference as occurred in 2009, but it’s enough to lead to a fresh surge in storage demand. More than 115 million barrels were in floating storage as of mid-September, down from 132 million in early August—more oil than the entire world produces every day.

More than 100 million barrels of oil are in floating storage

Over the past several weeks, oil traders are reported to have stored something close to 50 million barrels in tankers off the coast of South Africa and in parts of Asia. A Chinese trading firm is said to have leased the TI Europe, the world’s largest oil tanker, capable of holding 3.2 million barrels of crude. According to Bloomberg data, the ship is currently sitting off the coast of Singapore.

What’s different this time is that only the international oil market is in contango. In the U.S., where oil is priced according to the West Texas Intermediate contract, prices are expected to keep falling. WTI has fallen 11 percent since June, to $94 a barrel. In the futures market, the price of a barrel of WTI in March 2015 is $91. That’s mostly a function of the steady rise in production that’s expected to continue over the next year.

As a result, traders in the U.S. want to sell crude, rather than sit on it. The best evidence for that is the oil tanks in Cushing. Since it peaked at more than 50 million barrels in 2013, the amount of oil stored in Cushing has fallen by 60 percent, to around 20 million barrels.

Cushing is still relatively empty

Bloomberg