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.
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