Doing the contango

May 15, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

The current contango structure in crude oil futures and most other commodity markets — with future prices significantly above the spot market — is providing a strong incentive to buy and store record quantities of raw materials, with most of the cost borne by retail investors in exchange-traded funds and institutional investors in long-only commodity indices.

This “cash-and-carry” strategy rewards market participants with access to storage or finance at the lowest cost. It is providing huge profits for physical commodity merchants, investment banks, and the owners and operators of warehouses and tank farms during the downturn, and helps explain the record profitability from commodity operations reported recently by some of the largest banking and trading groups.

In the current market, the cash-and-carry strategy rewards well-connected “insiders” such as investment and commercial banks able to secure almost unlimited financing at zero-cost as a result of quantitative easing programmes.

DOING THE CONTANGO

In a contango market, the Futures Price = Spot Price + Finance (interest rate on the money borrowed to own the physical commodity) + Storage (cost of hiring tanks, tankers or warehouses) + Insurance (premiums for insuring the commodity against loss, sinking, damage, theft etc). Click here for PDF. More generally, the equation can be re-written to cover any market (whether contango or backwardation, when the futures price is below spot) so the Futures Price = Spot + Finance + Storage + Insurance – Scarcity/Prompt/Convenience Premium. The prompt premium is the additional price a consumer is prepared to have spare material on hand “just in case” rather than risk having to go out into the market and buy it at an uncertain price or even find it is unavailable.

When commodity inventories are low, the convenience/scarcity/prompt premium can become very large and dominates all the other terms in the equation, ensuring the futures price is below the spot, and the market is in backwardation. But otherwise the term is small and the cost of finance and storage exceeds the convenience/prompt premium and the market is in contango.

In practice, we can ignore the insurance term because (a) it tends to be quite small and (b) does not change very much. For this analysis, we will also ignore the prompt/convenience premium since markets are well supplied at present and expected to remain so for the foreseeable future, with high stocks of crude oil, aluminium and other commodities.

In this simplified world, Futures Price = Spot + Finance + Storage. In some sense, the futures price is above spot because by buying forward the purchaser avoids the finance and storage cost. Conversely, the spot price is at a discount because buying now and holding into the future incurs finance and storage charges.

So far, we have assumed the finance and storage costs are the same for all market players. But in practice the cost of finance varies over time and among market participants. On the storage side, the cost depends on whether you own tanks/vessels/warehouses; whether you have leased them on a long-term deal; and whether a special discount is available.

In principle, the Future Price = Spot + Finance + Storage relationship should hold for the marginal market participant doing the storage and reflects the marginal players financing and storage charges.

But for everyone else with lower financing and storage costs the actual cost of storage should be below the cost reflected by the contango. For these players, it pays to buy physical commodities, put them in storage, and then hedge the long physical position with a short futures position, pay the smaller storage and finance charges on the physical and receive the larger yield from the contango.

REWARDS FOR INSIDERS

Market participants with access to cheap finance (banks) or cheap storage (tank farm and warehouse owners, or those with long term deals) can make money on the physical deals.

This is one reason many commodity firms run a physical trading house and a warehousing company in tandem together with a futures brokerage. The point is to exploit synergies and run a balanced business that is somewhat insulated from the cycle.

The physical trading business directs metal to the warehousing company and tries to ensure they are full (and therefore earning rental income from the metal). Whether the company takes the income as rent (accruing to the warehousing arm) or as a cheap rent deal (with extra contango income accruing to the physical trading desk) is a matter for the tax accountants.

But it creates an attractive synergy. When the economy is booming, warehouse stocks will be low, so earnings on the warehousing company are poor, but futures turnover is usually high in a bull market, so the futures brokerage and speculative book make money. When the economy is in recession, futures turnover drops and commission earnings fall, but the warehouses will be full earning plentiful rental income.

Only a small number of metals trading companies are fully integrated (comprising a customer-oriented broker, a physical trading business, and a warehouse). But most others will have special arrangements with one or more warehousing companies. There are similar systems in oil — with banks taking leases on tank farm space or floating vessels to play the same strategy.

BACKWARDATION RISK

So far we have assumed that the physical and financial parts of the store and hedge game mature at the same time (ie the lease on the storage space and the futures positions mature on the same date). In this trade, there are no risks.

But it may be possible to spice up the returns by accepting some risk by mismatching the two legs of the deal. A close look at the shape of the futures curve reveals that the steepest contango is usually for the first day or month, with progressively smaller contangos thereafter.

Instead of taking a 3-month lease on some storage space and putting on a short position 3 months forward to hedge it, some physical traders will take a 3-month lease and put on a short position 1 month forward (earning the biggest bit of the contango) with the assumption they can roll the short forward by another month and then another when the correct time comes.

The risk here is the market flips into backwardation at some point before the 3 months is up. In which case rolling short positions forward will incur a cost not generate revenue.

Either the backwardation has to be paid (reducing total returns on the strategy) or the metal/oil has to be delivered before the 3 months are fully up against the maturing short position, in which case the player is paying storage costs on empty tanks/warehouses.

Long-term storage plays popular with many banks and trading houses at the moment, where shorts are repeatedly rolled, are a bet that the market will not flip into backwardation, and no one will organise a squeeze, before the storage deal matures.

This seems a fairly safe bet in the current environment of cheap money and plentiful inventories.

16 comments

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The current realities of commodities of all ilks in globalized trading hasn’t always been the case, producing the contango and I dare say abuses in the form of profiteering to the end consumer by those who never take delivery on the product.

The last Great Depression of the 1930s identified open futures commodity markets to those other than producers/suppliers as an element which compounded the pain and deepened the crisis, thus these markets were created to hedge risk for the producers/suppliers, stabilize pricing and decrease volatility. It made supply/demand markets more transparent and predictable.

In 1999 the US enacted the Commodities Futures Modernization Act (CFMA) written by then senator Phil Gramm. Afterwards, Mr. Gramm was vice-chair of UBS. This game changer was attached in the dead of night to unrelated must pass 1200 page legislation the night before it went to the floor. It included the Enron Loophole and other technical outs. Since its passage, the volatility and manipulation in the futures markets have provided financial houses yet one more means to stick it to everyone coming and going except of course, themselves. If it were just metals and oil one could say its the price of doing business and fair game but it isn’t. It include base grains, leaves out and pressures developing nations, producing shortages of real food for real mouths and starvation of people. This type of mindset and paradigm is a root cause to the current economic problems otherwise. Not a shred of INTEGRITY can be found.

Today supply/demand in particular commodities, like oil, is totally opaque but it will drive legislation for things like cap and trade based on ‘peak oil’ and other mushy unsubstantiated or clear basis for changes in major markets and creating new OPAQUE markets. Despite the continuing decline in gasoline use, the pricing continues to rise, mixed messages in reporting by government(s) on economic data monthly or annualized still isn’t reflective of the reality of the end consumer who is, like it or not, a participant and element of commodity markets.

Legislation passed in ’08 and ’09 Farm Bill have subsidized and encouraged growing corn for ethanol, the near-monopoly of big AG have already exceed the mandate set forth 2 years ago and now are lobbying for more. This means the grains for people and animals are increasingly supplied from foreign sources, some of which have mandated protein content cooked by using the industrial chemical Melamine to foil protein content tests. Problem is, too much Melamine and it shuts down the kidneys of those who consume it, particularly infants and children. It translates into products of the animals fed these grains including eggs.

I want to create a market to trade the liars, crooks and thieves for which the USA has a bumper crop and includes not only those who have endlessly gamed the system in their favor without producing anything except digital trades (claiming this produces “price discovery”) but also for those who abdicated their responsibility in government to ‘serve’ the public. We’ve been served UP instead.

Time to repeal the CFMA, close these markets internationally to these traders who have no interest but self-interest.

It doesn’t escape the attention of the US taxpayer that Merrill/BoA, Goldman Sachs, et. al. are buying and storing oil (and have been) taking tankers out of mothballs, renting them to the tune of 75K a day on the taxpayer dime, only to use their ability to do this to hit where it hurts most in energy pricing for the coming winter and households.

Posted by NS | Report as abusive

The comment by NS is so filled with misconceptions, erroneous conclusions, and enough liberal crap to lead one to the conclusion he is a closet socialist. Who is to make market judgements then, some bureaucrat in DC. Maybe, the same ones who thought up ethanol when basic economic research proved ethanol consumed more energy that it produced.

The above mentioned cash and carry trade is one of the best examples of market forces at work. It clears the market of excess supply, rewards capital investment in storage, and promotes supply at lower cost.

Posted by howard james | Report as abusive

I must confess to have found this article slightly technical and hard to grasp, although the “Not a shred of INTEGRITY can be found” line probably sums it up. Hopefully the roasting that is happening to our politicians in the UK is the beginning of returning INTEGRITY to the markets, from the top down. I don’t believe it’s too late, and I think it’ll be relatively easy to rectify the problem as it seems to be coming from a relatively small number of “players”. It will be messy. (It’s probably ironic that INTEGRITY was one of Gordon Browns favourite words before the fan was covered in the smelly stuff.)

Posted by Peter H | Report as abusive

The public is getting screwed again with its own tax money. Using bail out funds to speculate against the public interest at this critical time in the business cycle is a shame. Its blood money for sure.

This is one clear reason why the average consumer should not confuse market rallies with the underlying economic realities. The rally in crude from US$35 pb to roughly US$60 per barrel doesn’t really mean demand has returned due to a rebounding global economy, it could be all due to “derivative math”

Posted by Jason | Report as abusive

Good article. Thanks to the author.

Posted by Sergey | Report as abusive

I wish John Kemp would learn to write in the English language instead of painful techno-babble.

Posted by Richard Garnett | Report as abusive

Just another thing that destabilizes the economy. Unless congress can stabilize the economy it is about to go into a flat spin out of control. We went through the first stall point and got the nose down, and now wall street wants to pull the nose up just to make profits.
When you pull the airplane up again without leveling the flight this stall will be like comparing a ladyfinger cracker to a M 80. I do hope the congress stabilizes the commodity market and the stock market, or we might just become an also ran.

Posted by f belz | Report as abusive

It is certainly a shame that today the word “profit” is such a bad term. It really doesnt matter if oil goes up, someone or someones are to blame, if it goes down someone or someones are to blame.Those nasty oil companies and speculators drove the price down from 147 and the same are manipulating the price up. Maybe it would be better if oil companies lost money then we could bail them out too? It wasnt too long ago that GM was nasty for making a profit and making people buy their cars.

Posted by Lampell | Report as abusive

Seems like I remember reading about contango in the oil markets in John Hussman’s weekly market column almost a year ago. That was at a time oil prices were over $100/bbl and heading higher. Remember the talk of $200 oil?

Hussman pointed out that contango signalled that we were nearing the end of the speculative ride as it had a year before that, while he cautioned that the final frenzy could send the price vertical before it crashed. Of course, that’s what happened,although it took another six-eight weeks before the crash came.

None of it had anything to do with supply. It was all speculation. My hope is that the next crash finally collapses some of these trading houses ao we won’t be forced to bail them once again and allow them to trade on our nickel.

Posted by Mike G | Report as abusive

thanks for the write-up, was an interesting read. If you’re interested, we’ve also taken a look at contango and how it affects the oil exchange traded funds (ETFs) in financial markets (a.k.a. the way everyday investors can buy crude oil). The results were definitely quite interesting as various vehicles suffer during contango and others benefit. This is definitely some information that investors need to pay attention to when investing in crude oil: http://www.marketfolly.com/2009/01/how-c ontango-affects-crude-oil-etfs-and.html

Thanks again for your perspective.

Jay

John Kemp is writing in clear, and perfectly understandable English, although he does introduce some technical terms to the uninitiated as he tries to explain ‘basis trading’. As a former basis trader in soft-commodities, and later a futures & options trader in oil & gas, I can tell you that basis trading is absolutely nothing new, and has been going on for centuries. Research rice trading in ancient Japan. The key to successful basis trading is supply and demand analysis. That the government is handing out free money to banks is the whole purpose. They are trying to kick start demand again. Banks with access to cheap money can lease tank farms and help suck up some existing supply from the market until demand recovers. They do not magically produce end demand from users. That is up to the economy as it recovers. Alternatively banks can on-lend money to solid companies involved physically in commodities, metals and energy. That cost of capital is only one part of the equation. If credit was more expensive then the contango would increase. Not decrease. As excess profit is arbitraged away. Anyone with a spreadsheet can replicate these basis trades. But you still have price or market risk. What John Kemp is describing is professional investors taking measured bets on market direction. They are also competing against themselves, so the balance between supply & demand is not a one-way bet as the article might imply.

Posted by MrBill, Eurasia | Report as abusive

Mr. James: you provide no basis for your statements. If this is true, then explain demand destruction in petrol products and the excessive profits of US oil companies (over a trillion via testimony on to Congress) in the first 6 months of last year. I have the business report of the first half of last year which Goldman-Sachs made 2 billion just in futures oil trades. Just one brokerage, just one commodity. And what exactly did they produce for these profits, certainly NOT ‘price discovery’.

Profits are not evil but the expectation of marketeers of manipulated triple digits verses the earned high single digit one is a root problem to this market and the equities markets. The ability to determine Value is what is destroyed in this environment and confidence.

I challenge you to look at the wheat spot last year and tell me the same thing again. If you read more closely, you will note that ethanol production, cap and trade are based on these occlusive markets and not one which this reader finds favorable or desirable. Its unsubstantiated and is also unsustainable. Read again a little more carefully.

Posted by NS | Report as abusive

Like the Macarena, but more deadly.

It supposedly takes two to contango – that would be, at least one who makes or legitimately purveys the goods, and another party entirely betting the outcome in terms of availability and consumer predisposition when the goods are due to meet market. Vision and a certain willingness to take risk in exchange for profit potential being not unreasonable to reward.

When however arbitrageurs so very much fancy themselves that they become so-called entrepreneurs of the grotesque ilk described in this article, the two parties above have become one and the same, which is odd to say the least and decidedly not visibly accountable by the rules of regular capitalism, including the fiscal principles underlying this economy.

The inevitably resulting market scarcity of essential commodities is synthetic, not to say jacked-up, while the means by which the preneur involved came by his betting cash for this game of his own making is questionable at best, no matter how much of it there is nor how freely it flows, and flows only his way only – not the same way it seems to flow – namely, away – from at this time generally cash-strapped taxpayers.

The contango being danced here is more like something out of Fight Club, except that here the partners aren’t even pretending to be two different people. Instead of fighting nobly against one another to see who gets the upper hand or as it were stays erect longer, they are ogling and plying one another with seemingly infinite amounts of Spanish Fly to see what manner of offspring their hellish union might produce.

Reuters readers are not alone in having a hard time telling apart this form of casino capitalism gone wild from felony insider trading. Let’s call this song exactly what it is: insider trading whose extent and venality appears destined to sabotage the entire economy formerly known as capitalism, from within. And we all know what’s supposed to happen to inside traitors- I mean, traders.

Posted by The Bell | Report as abusive

The question which should be asked here but isn’t: why has the contango been so steep?

Posted by Mallory Margueron | Report as abusive

Great piece!
But actually it takes 3 to contango!

(1) Consumers of the commodity who are not willing to pay higher spot prices than the storage arbitrageur is willing to pay. (See for instance the Nat Gas contango in a fast falling spot price market.) In other words contango usually only exists with surplus supply.

(2) Speculators or Commercial buyers who are willing to buy the market forward such that prices are higher forward than spot. These are the folks who by being willing to pay higher prices in the future than prices now, allow the storage arbitrageur to make near risk free profits by buying spot and selling forward. Indeed (as oil last year) if there is super speculator demand then they can outbid the consumer in 1 above allowing contango to exist in the absence of supply glut.

(3) The storage aribitraguer – the insider with access to capital and storage who can take advantage of the trade. Whilst legally strictly speaking a speculator, however in reality this is as near to a risk free trade as one can get.

Why does the arbitrage get large and the contango get steep … well in some markets it is non-existent: Gold for instance – since the barrier to entry is small. Almost anyone can buy a few Gold bars stick them under their mattress (uncomfortable!) and sell them forward.

In others it is huge (look at Nat Gas spot at $2.20 against the November futures contract at $3.75 where the contango carry is at a stunning 55%) because (a) the barrier to entry is very very high – who has access to caverns to store Nat Gas, to pipelines to transport it, to swap lines to convert Henry Hub to Hubs near storage and so on? and (b) seasonal demand will lift price in Winter when most Nat Gas is consumed (almost 2 x the summer) and (c) storage is very limited.
MW

Posted by MW | Report as abusive