Thursday, April 16, 2009

Oil Futures: Money for the Taking?

Maybe someone who knows more about oil than I do can explain this to me. As best I can tell, there is money for the taking, at virtually no risk, available in the oil futures market right now. As an economist, I have a hard time imagining how that can be: when there is money for the taking, we usually assume that someone will already have taken it.

Physical oil is selling for about $50 a barrel today. Just for a specific example, the contract for May delivery of light, sweet crude closed at $49.88 on the NYMEX Thursday. Distant futures contracts, however, are trading at much higher prices, a situation known as contango. Ordinarily contango can be explained by the costs of financing and storage, but today’s contango seems too extreme to admit of that explanation. For example, the December 2010 contract closed at $66.68 Thursday – more than 33% higher than the May 2009 contract.

It seems like a no-brainer: buy some oil, put it in a tank, sell the distant futures, and then just wait. Some time between now and December 2010, either the price of the oil has to go up, in which case you make money by selling the oil, or else the price of the futures has to come down, in which case you make money by buying back the futures contract. The costs of financing and storage can’t be anywhere near large enough to eat up the profit that you’re locking in with these transactions, and the basis risk – the risk that the oil you buy won’t sell for exactly the price of the deliverable oil for the futures contract – has got to be tiny compared to the available profit.

If you annualize the difference in the futures contracts, it comes to 20.1% or $10,036 for 1000 barrels of oil. Admittedly knowing little about the market, I just can’t imagine that it costs more than a few thousand dollars to store 1000 barrels of oil for a year. So we’re looking at an implied financing rate in the high teens. If you can finance, say, at 10% (which shouldn’t be too hard for a well-established institution that can offer 1000 barrels of oil as collateral and show that the futures contract will assure the ability to pay back the loan), you can pocket the difference.

Anyhow, we don’t really need to talk about the financing and storage costs for a hypothetical arbitrageur that needs to borrow the money and store the oil. There are plenty of oil producers that have the option of storing the oil in the ground at zero cost. Unless they’re desperate for cash (which seems unlikely given the amount that many of them piled up when oil prices were high), it’s a puzzle why they continue producing at over 90% of capacity. Why not just sell the futures, put off the extraction until late next year, and either sell the oil at a higher price or buy back the futures at a lower price?

And even if they are desperate for cash, it’s still a puzzle. Given the huge amount of highly liquid US Treasury bills in circulation, it’s clear that not everyone is desperate for cash. Some are just highly risk-averse and don’t want to invest their cash right now. But this arbitrage offers them a risk-free investment with a return much higher than that of T-bills: pay an oil producer today for some oil to be delivered in December 2010, sell the futures contract, and then wait. You can offer the producer more than today’s price of oil, so it will certainly be in the producer’s interest to accept your offer: they get the cash now, and they don’t have to send the oil until later. Meanwhile you’re assured of making money come December of next year: you either re-sell the oil at a higher price as soon as it gets delivered, or you buy back the futures contract at a lower price.

Everything I know about economics says that there ought to be so many people trying to do these transactions that they would already have driven up the price of oil or driven down the price of the futures contract to the point where no obvious risk-free transaction is possible. So why hasn’t it happened?


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

61 comments:

Hemant said...

My two cents on why the arb may not work
1) Some larger players, with access to oil tankers are doing this. Obviously not on a scale to whittle this down. smaller players dont really have access to tankers and such.

2) These are futures - NOT forwards. So you need to cash settle daily - and liquidity is at a premium. So thats a risk.

3) The point about the oil producers isnt really true. They are constrained by how much the pipeline infrastructure can produce and are operating at 100% of capacity anyway. So if a producer produces one less barrel now, he still cant produce one more incremental barrel in dec 2010 [ because in any event, he plans to be at full capacity in dec 2010] Complicated game theory / prisoners dilemma between producers.

Make any sense?

Anonymous said...

Geo political risk might be a big factor..

The market is TELLING you that consensus is $X/bbl. You can sell at that.. Sometimes you make more, sometimes you make less.

Further, you neglected transport costs. Futures are settled at the exchange, you must pay the truck/pipeline.

Not to mention opportunity costs.. But a house now for 70% off in some markets, or some of those distressed derivatives from the Govt.

Anonymous said...

What if all the storage capacity are saturated ? Maybe, this contango situation is reflecting an unprecedented level of inventories and limited possibility of extending those inventories ?

Highgamma said...

First, as someone has previously stated, all of the storage capacity that is near the point of delivery is saturated. (We've joked that we should take foreclosed houses, wrap them in bubble wrap and fill them with oil.) Even storage away from the points of delivery are full where people are taking delivery of oil or its products as inventory to take advantage of the contango in the market.

Second, oil wells are a tricky thing. If you don't produce them along an optimal "curve" you will get a less out of them at a greater cost over their lives. Most natural gas wells can be easily "shut in". Oil wells are typically shut in only at the end of their lives. (There are exceptions to this and you can factor in the costs of secondary and tertiary recovery techniques into your model.) This makes the production problem more dynamic than you have modeled.

Third, people who are selling need cash now. That is, their costs of borrowing are MUCH greater than the interest rate at which the Fed borrows. Many firms cannot borrow at all. The easiest form of "borrowing" is to liquidate valuable assets and use the cash raised as needed.

Finally, there are people taking advantage of this; however, the unexpected drop in demand has led to an avalanche of physical product in the system. The last time this happened was in 1998 and I would expect it to happen again sometime.

Henry Bee said...

Great comments. But they're all micro factors. A demand shock knocked many markets way past equilibrium. Oil price is definitely one of the victims. It can take longer than usual for markets to reach a new equilibrium when liquidity is constrained.

freude bud said...

Storage at Cushing actually dropped below 30 million barrels for the week ended April 10 according to the EIA, and NYMEX asserts they have about 40 million barrels of storage capacity, so I don't think its storage near delivery.

OTOH, commercial crude stocks built by 5.6 million barrels last week to the highest level of commercial crude holdings in storage seen since September 1990.

As Hermant pointed out, these are futures markets, not forward markets, and you are vulnerable to margin calls. Given that most don't want threats to their liquidity in the current market environment, and the historically huge price volatility of the front month contract seen in the last four months, oil is likely seen as a good way to get blown out by many.

Anonymous said...

Is anyone familar with the convenience yield. I remember talking about it in derivitaves class. Anyways I forget all the details, but basicilly this is not unusual behavior for oil markets. Since people prefere to enjoy oil now rather than in the future they forgo entering into an arbitrage agreement.

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