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.

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