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Oil traders dancing to the contango

By LYNN COOK Copyright 2008 Houston Chronicle

Dec. 16, 2008, 11:01PM

A market condition called contango, in which oil futures contracts going forward are higher than ones for the immediate future, has traders scrambling for crude storage as they attempt to lock in future profits.

Light, sweet crude for January delivery closed at $43.60 a barrel Tuesday on the New York Mercantile Exchange. A trader who enters a contract to buy then can lock in a profit by buying contracts to sell at a higher price a few months down the road.

Crude for June delivery closed at $53.10 per barrel on Tuesday, for example, and the condition continues indefinitely at this point. Crude closed at $58 for January 2010 delivery and at $64 for January 2011.

Phil Flynn, vice president at Chicago-based trading firm Alaron, said the oil contango has created a frenzy for storage space.

“You pay as much as $2 a barrel to store it but you can lock in the profit instantly today and make out like a bandit,” he said.

The scramble for oil storage, combined with reduced demand in the recession, has lifted U.S. inventory numbers to 321 million stockpiled barrels—an 8 percent increase over this time last year, according to the latest report from the Energy Information Administration.

Some companies reportedly are even storing crude in tankers, leaving them at sea instead of delivering their cargo.

Bruce Kahler, a ship broker at Lone Star, R.S. Platou, told Bloomberg News that Royal Dutch Shell is paying $86,000 a day for two to three months for the Leo Glory, a 2-million-barrel supertanker in the Gulf of Mexico.

“It’s speculation,” Kahler told Bloomberg. “These traders believe that ‘If I put a cargo in there now, I will make money later.’?”

Robin Lebovitz, a Shell spokeswoman, said the company does not comment on its trading activities. Shell’s supertanker contracts fall under that trading program, she said.

Guy Caruso, a senior adviser with the Center for Strategic and International Studies, told Deloitte’s Oil and Gas Conference last week that the strong contango market is really about the market finding its way again.

For the last few years investors have been running to oil as a hedge, assuming the rest of the world was decoupled from the U.S. economy, he said. That assumption turned out to be wrong.

Oil was overvalued. The dollar was undervalued. Now the recession appears to be global and for the first time since the Arab oil embargo of 1973, global demand for crude will go down for two years in a row, Caruso predicted.

“I believe it will be 18 to 24 months before prices will turn back up again, but I agree that they will be in the $60 to $70 range when it does happen,” Caruso said.

Flynn said it may seem counterintuitive but the market contango could help to moderate high prices in the future.

“Demand is down. That means the market is anticipating a supply glut but we know the world needs more energy going forward,” Flynn said. “But low prices are derailing a lot of oil projects. That could create a shortage once economies start to recover. What the market is really doing here is putting oil away for a rainy day.”

Oil’s contango could also signal the market is worried about U.S. economic fallout. A weak U.S. economy, government bailouts and the Federal Reserve’s willingness to print more money all point to dollar devaluation against other currencies going forward.

“We’ve already seen that effect,” Flynn said. “A weaker dollar means oil will be more expensive down the road.”

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