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08 December 2008

Royal Dutch Shell Contango

Put simply, a contango is what happens when the price of a commodity is anticipated to go up. A commodity is bought in bulk and stored for a period of time, to be resold at a profit. The cost of storing the commodity is taken into consideration in calculating the future sale price. The main thing is that the commodity must be non-perishable. If it is perishable, the commodity does not fit into the concept of contango, because it will grow stale or mature.

In short, contango means stockpiling for resale (with profit).

From Wikipedia

Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a forward curve is said to be "in contango" (or sometimes "contangoed").

Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price, or a far future delivery price higher than a nearer future delivery.

The opposite market condition to contango is known as backwardation.

A contango is normal for a non-perishable commodity which has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold).

The contango should not exceed the cost of carry, because producers and consumers can compare the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs can sell one and buy the other for a risk-free profit too (see rational pricing – futures).

If there is a near-term shortage, the price comparison breaks down and contango may be reduced or perhaps even reverse altogether into a state called backwardation. In that state, near prices become higher than far (i.e., future) prices because consumers prefer to have the product sooner rather than later (see convenience yield), and because there are few holders who can make an arbitrage profit by selling the spot and buying back the future. A market that is steeply backwardated — i.e., one where there is a very steep premium for material available for immediate delivery — often indicates a perception of a current shortage in the underlying commodity. By the same token, a market that is deeply in contango may indicate a perception of a current supply surplus in the commodity.

There is presently an opportunity for contango in the crude oil market. Many players consider the stockpiling of crude oil as a low risk opportunity, because crude oil may be at its lowest price. Bloomberg reports that Royal Dutch Shell has a supertanker holding up to $80 million of crude oil off the shore of the UK. At least 16 other supertankers are also anchored along with it, altogether capable of holding 26 million barrels worth about USD$1 billion. Shell and Koch Industries have chartered four supertankers to ship crude oil from the Middle East to take advantage of the expected rise in crude oil prices in the coming months. [Source: Bloomberg, 8th Dec. 2008. Contango Pays Most In Decade As Shell Stores Crude]

Parties seeking to capitalize on this opportunity have to act fast. This window of opportunity could close if OPEC decides to cut oil production and therefore remove excess crude oil from the markets. The OPEC meets on 17th Dec. 2008 in Algeria. There is also danger that the contango will need a longer time to bear fruit if China slips into recession and OPEC fails to respond by cutting output. Francisco Blanch, head of commodities research at Merrill Lynch UK, anticipates that in such an event the price of crude oil could come to USD$25 per barrel. [Source: Bloomberg, ibid.]

On the other hand, if the Chinese economy does not falter, Merrill Lynch predicts that crude oil prices will rise to USD$56 by the second half of 2009 and USD$70 by 2010. Joe Petrowski, CEO of Gulf Oil, warned that crude oil prices could fall by USD$20. [Source: Financial Post (Canada), 5th Dec. 2008. The impact of weak oil on gasoline and producers] Sanford C. Bernstein & Co. estimates the break even point for the crude oil industry to be at USD$35 to USD$40 per barrel. [Source: Wall Street Journal, 4th Dec. 2008. Oil's Slide Set To Leave Dark Trail.]