In 2008, as money rushed out of the oil market and prices continued to collapse, a bottom for oil was nearly impossible to find. But one commercial factor gave a singular reason to buy front month futures when prices neared $40 and below: A 'free money' carry trade. Such an opportunity is again emerging in 2015 and heralding a bottom in oil prices.
Let me describe what the carry trade looks like: When prices disintegrate quickly in the oil market, as they did in 2008 and today in early 2015, the money disappears much more quickly in the 'near' months: Oil for delivery in February of this year, for example, closed yesterday at $48.65 a barrel. But the price for oil for delivery for February of next year in 2016 is $56.18, or almost 8 dollars more expensive. This is a condition we call 'contango', where prices on the 'back' of the curve are higher than those at the front.
A 12-month contango of $8 is plenty to start to initiate a 'carry trade' for commercial oil producers and here is how it works: If you can secure storage (not easy), you can buy the front month oil, put it away for a year and collect $8 a barrel when you deliver again in 2016. Your costs are only the cost for storage and the 'money float' that you lose in 'banking' saleable oil for a year. In both cases, if you find cheap enough credit (very easy), you've got it made: You can collect about $5 a barrel of 'free money', or more - a lovely return on a year's investment.
Koch Industries was one of…
In 2008, as money rushed out of the oil market and prices continued to collapse, a bottom for oil was nearly impossible to find. But one commercial factor gave a singular reason to buy front month futures when prices neared $40 and below: A 'free money' carry trade. Such an opportunity is again emerging in 2015 and heralding a bottom in oil prices.
Let me describe what the carry trade looks like: When prices disintegrate quickly in the oil market, as they did in 2008 and today in early 2015, the money disappears much more quickly in the 'near' months: Oil for delivery in February of this year, for example, closed yesterday at $48.65 a barrel. But the price for oil for delivery for February of next year in 2016 is $56.18, or almost 8 dollars more expensive. This is a condition we call 'contango', where prices on the 'back' of the curve are higher than those at the front.
A 12-month contango of $8 is plenty to start to initiate a 'carry trade' for commercial oil producers and here is how it works: If you can secure storage (not easy), you can buy the front month oil, put it away for a year and collect $8 a barrel when you deliver again in 2016. Your costs are only the cost for storage and the 'money float' that you lose in 'banking' saleable oil for a year. In both cases, if you find cheap enough credit (very easy), you've got it made: You can collect about $5 a barrel of 'free money', or more - a lovely return on a year's investment.
Koch Industries was one of the biggest users of this carry trade opportunity in 2008, when the 12 month contango went as high as $15 - but today credit conditions are a lot easier than back then and this trade is attracting other private traders and oil companies like Shell, Vitol and Trifigura.
The irony is that you don't even need to buy front month oil, if you are a producer like Shell or the Kochs - you simply contract the storage and put away cargoes of crude instead of selling them in the prompt markets - which amounts to much the same result.
What has happened in the last few weeks has been predictable: Storage in key nexuses like Cushing, which had been ample all through the Fall, disappeared in a matter of days. Large tankers which carry oil (VLCC's) have been contracted not to transport, but merely to hold product, sitting full for months bobbing aimlessly.
And lots of physical oil that was destined to hit the cash markets just doesn't show up.
Is that supply constriction enough to turn this free falling oil market around?
Well, it helped a lot in 2008.
And it's the first real reason I've seen to believe that oil is nearing a bottom.
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