Let’s Do the Contango
I have been fortunate to visit Buenos Aires many, many, many ( yes that many) times . Work related of course but I managed a few hours now and then to explore the city.
You can see the blend of Spanish and European cultures; it is a beautiful city. Buenos Aires is known for great food, great wine and the Tango.
The origins of the Tango began with the immigrants and working-class people who lived near the ports in Buenos Aires in the 1800’s .
Today there are many versions of the Tango. If you do happen to go to Buenos Aires, San Telmo is a fun outdoor market with plenty of local tango dancers out in the plaza.
Hang on. Is this an investment article or a travel blog?
This is an investment article, but it is not about the Tango. It is about Contango.
The financial market headlines have been full of stories about negative oil prices. Negative oil prices? What does that mean? Last time I filled up the tank, gas was certainly cheaper, but no one was paying me to fill up the tank. I was missing something.
Then I read beyond the headlines and the real story came out. There was a technical problem in the pricing of futures contracts in the oil market. “Ah-ha” I said. Now I get it.
Few people would get it unless they are commodity traders. As a result of a “technicality” in the pricing of oil futures contracts, the oil market was in contango.
I can’t turn you into commodity traders, but I can give you a leg up on the terminology.
By the time you are done reading this article you will be able to jump into any conversation on negative oil prices.
Here, try it on with a friend:
“The negative oil price is really due to the pricing of oil futures contracts. The negative pricing that occurred caused contango in the oil markets”. Say it with confidence.
This investment article is focused on the following (so you can say it with confidence)
- One : What is a futures contract ?
- Two: How are commodities traded?
- Three: What is contango?
I could add : “Why do I need to know this”?
I like this story because it explains the 27 oil tankers floating around the port of Los Angeles/Long Beach. Three tankers would be normal.
Gas may be cheap but most of us are not driving, so what then?
Futures Contracts
Futures contracts are not some new diabolical financial instrument. Futures contracts have been used in financial transactions for over 400 years. The contract is a way for a buyer of a commodity and a seller of a commodity to agree on a price, in the future !
Think of buying or leasing a car. You and the dealer agree on a price and the cost of financing. If you buy a car, the terms of the contract will tell you how long it is going to take to pay off the car in the future. If you lease a car, you and the dealer agree on the number of miles you can drive, the financing cost, the monthly payment, the price of the car and the end date of the lease. The end of the lease is an agreed upon date in the future. You deliver the car back to the dealer. The commodity in this example is the car.
Futures contracts for oil have many of the same features.
A futures contract could be one year or several years. The contract has an agreed upon price. There are embedded costs like shipping, financing, insurance and storage.
But an important feature of a futures contract is this. If you buy a futures contract for oil , before the contract expires you can either sell the contract or take delivery of the oil. You must do one or the other before expiration.
Oil doesn’t come out of the ground and go directly to your gas tank. Oil must be refined, transported and stored before arriving at your local gas stations. Each step has a cost.
The buyer of oil takes all the costs into consideration before agreeing to a “price per barrel”. The seller of oil has the costs of getting the oil out of the ground. And of course, both buyer and seller need to make a profit to stay in business.
Here is a hypothetical example:
A year ago, the buyer and seller of a futures contract agree on a price of $40 a barrel. When the contract is due to expire a year later (last week), the buyer will pay the oil supplier $40 a barrel and take delivery of the oil. Or, the buyer can sell the contract and not take delivery, leaving the oil producer with a bunch of oil.
The buyer who does not intend to take delivery of the oil, is an investor who must own futures contracts to gain “exposure” to the oil markets.
Futures are used widely in mutual funds and exchange traded funds. The buyer sells the contract that is about to expire and then buys another contract with a longer expiration date.
What has happened during the year is the coronavirus. Keeping people at home. Not driving.
The demand for oil and gas at the pump has plummeted. Today, the buyer of oil is not going to pay $40 a barrel because the price of a barrel has dropped to $10.
The supplier of oil now has a big problem. What to do with all the oil if no one will buy it? The supplier expected to receive $40 a barrel upon delivery. Now, the supplier must PAY THE BUYER to take the oil. In either case, oil must be stored somewhere until it is sold.
Ever feel as though you have run out of storage capacity in your own home? And all the public storage spaces are gone? What do you do with all the stuff?
This is what is happening in the oil markets. Storage capacity is limited and there is nowhere to put the oil, except for supertankers.
So back to the negative price.
In my fantasy world it would be like this.
I go into a Hermes store, just to look around. One of the salespeople approaches me and says “ Do you like this scarf? We will PAY YOU $200 to take it with you”. What??? I get the scarf plus $200?. That’s why it is a fantasy.
It cost Hermes $200 to produce the scarf. But now they have SO many scarves they are paying customers $200 to take them. Instead of making a profit when they sell the scarf, they have now incurred an additional cost . The cost went from $200 to $400 dollars. They now have a realized loss of $400 per scarf. I’d say that’s a negative.
In the futures market, when the price of an oil contract drops as the contract nears expiration, say $40 to $10, and the cost of a longer dated contracts goes up, the condition is called contango.
Contango is not what you desire in the futures market, and I can tell you there has been a lot of dancing around the last few weeks to get out of oil futures contracts.
In the world of commodities, a lot can wrong between now and a year from now. Buyers are not willing to pay a higher price for a world of uncertainty.
Back in the real world , as more supertankers head to port, the owners of supertankers are happy because their industry has been flat on its bum for years.
Remember when you are having this conversation with a friend that the negative price did occur in the futures market. This is the piece of information that was missing from most headlines.
There is a name for a “normal” commodity futures market. It is called backwardation. Yeah, not going there today.
Resources for this article include:
US oil prices turn negative as demand dries up.
BBC News April 20, 2020
https://www.bbc.com/news/amp/business-52350082
What Negative Prices Tell Us About the Future
Wall Street Journal April 25, 2020 8:03 am ET
https://www.wsj.com/amp/articles/what-negative-prices-tell-us-about-the-future-11587816180
“Oil prices grabbed headlines this week as front-month oil futures contracts (i.e., those expiring next) for two key pricing benchmarks crashed and burned on Monday.
The Motley Fool April 21, 2020
https://www.fool.com/amp/investing/2020/04/21/beyond-the-negative-headlines-oil-prices-arent-wha.aspx
Chicago Mercantile Exchange – CME Group
https://www.cmegroup.com/trading/why-futures/welcome-to-nymex-wti-light-sweet-crude-oil-futures.html
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