No Risk-Free Gains Here

Beware. The oil market is in a state of ‘contango’.

Don’t worry, it’s not something to scare you, it’s just something that happens in the commodity markets.

It’s when the spot price (the price to buy today and take delivery in two days) of a commodity is lower than the price to buy and take delivery in the future.

You can see this in the futures price curve below:

Source: Bloomberg

Click to enlarge

If you wanted to buy a barrel of oil yesterday, you could do so for around US$31.91 per barrel.

You could then, theoretically, take delivery of that barrel, stick it in the garage, and then sell a December 2016 futures contract for US$39.24.

At that point, when the futures contract expires, you could deliver the barrel of oil and collect your US$39.24.

That would be a clear profit (not including transaction costs) of US$7.33 — a 22.9% return on your money.

Easy, right?

If only it were so. For a start, you’d probably find it tough to buy enough barrels of pure crude oil to make the exercise worth it. 100 barrels would give you a US$733 gain.

200 barrels would give you a US$1,466 gain.

That’s probably a bit more like it. Only problem is, where would you keep so much oil? Odds are that your local council probably has a covenant preventing the storage of several hundred barrels of crude oil on residential land — spoil sports.

There’s got to be another way.

Canada’s Globe and Mail reports:

The world is awash in oil and could be running out of places to put it. It’s a situation that prompted the head of oil giant BP PLC to joke that every swimming pool and storage tank will soon be brimming with crude, which is cheaper than it’s been in 13 years.

Oil traders and speculators, however, are looking to stash their oil at sea, in hopes they can sell it at a profit in a few months as prices rise.

A growing number of the world’s oil ships are set to be used as floating storage, analysts say, as traders gamble that the rise in crude prices will more than cover the $50,000 (U.S.) a day it costs to rent and anchor a ship that can hold enough oil to fill 127 Olympic-size swimming pools.

The cost of using ships as oil storage vessels, according to the report, works out at around US$1 per barrel.

Using our example above, if we stored the oil on a ship, it would cost us US$10 for storage. That would chew up our US$7.33 ‘profit’, leaving us with a US$2.67 loss.

Drats!

If you’ve traded commodities, or even traded stocks during a corporate action, you’ll know that the ‘cost of carry’ is generally always built into a price.

If it wasn’t, big market players, often called ‘arbitrageurs’, would identify the pricing anomaly and place trades that would help them make a risk-free profit.

The point of this is that if you’re trading the ‘contango’, there isn’t a risk-free profit at the point of making the trade. The profit will only develop if oil prices rise or storage costs fall.

If not, traders potentially face a big loss. Remember, they know their maximum loss is the difference between the futures price and the cost of storage.

But because it’s a relatively small amount on a per-barrel basis, traders will do what they always do — they’ll leverage their position as much as they can.

That in itself could exacerbate the problem, because that involves buying oil in a market that’s already experiencing a glut.

The resources boom may be long over, but the effects of the bust aren’t. That’s still playing out in the market today, and will likely impact markets and prices for many months to come.

This won’t end well

Each crude oil futures contract covers 1,000 barrels. At the current price, one contract is worth US$31,970.

On Wednesday, 632,515 contracts traded on the US market. That’s US$20.2 billion-worth…in one day of trading…on one oil contract.

Just saying.

What could they mean?

Don’t for a moment think that any central banker or Western government has given up on the idea that money printing and low interest rates are good for the economy.

The Financial Times reports:

The IMF on Wednesday warned the G20 participants in a briefing note that global growth this year was already worse than expected as financial conditions tighten in advanced economies due to market ructions. It also pointed to the rising stress in emerging economies and the increasingly acute situation facing oil producers in the developing world, many of which have already run through their fiscal buffers.

“These developments point to higher risks of a derailed recovery, at a moment when the global economy is highly vulnerable to adverse shocks,” the IMF warned.

“The global economy needs bold multilateral actions to boost growth and contain risk,” it added. “The G20 must plan now for co-ordinated demand support using available fiscal space to boost public investment and complement structural reforms.”

Hmmm. What could the IMF mean by ‘co-ordinated demand support’? It couldn’t possibly mean more money printing and, perhaps, negative interest rates could it…could it?

Pick up the phone

Here’s something that will interest our resident tech expert, Sam Volkering. This also from the FT:

A scam in which criminals impersonate the email accounts of chief executives has cost businesses around the globe more than $2bn in little over two years, according to the US Federal Bureau of Investigation.

The FBI has seen a sharp increase in “business email crime,” a simple scam that is also known as “CEO fraud”, with more than 12,000 victims affected globally.

In the scam, a criminal mimics a chief executive’s email account and directs an employee to wire money to an overseas bank account. By the time the company realises it has been duped, the money is gone.

The average loss is $120,000 but some companies have been tricked into sending as much as $90m to offshore accounts, US authorities say.

The saying is that crooks are always one step ahead of the good guys. This is perhaps another example. In a way, it’s going back to basics.

It’s not necessarily using fancy viruses to infiltrate a corporate IT network; it’s pure hacking activity. Getting in, pretending they’re the CEO, and getting the poor sap in accounting to transfer $50,000 or so to an offshore account.

In many businesses, that wouldn’t be an extraordinary request.

From now on, if the boss sends you an email to wire funds overseas, it might be worth picking up the phone and confirming the request…just hope that they haven’t hacked the phone lines either.

In the mailbag

A comment from a reader on yesterday’s Port Phillip Insider:

Excellent. Please write more articles on how to read P&L, Balance sheet or trading statements. In particular how to pick up value for money when stock prices are down. Kind regards, CL

We’ll do just that. I’m working closely with analyst Ken Wangdong on a number of projects at the moment.

Ken is a whiz with spreadsheets and valuing stocks. Expect to see more of our work here and elsewhere.

Cheers,

Kris

From the Port Phillip Publishing Library

Special Report: The biggest stock gains can come from the least likely places. While the ASX fell 9% in the 12 months to November 2015, one tiny, hated mining stock soared 1,200%. What seemed like an ugly, bad investment quickly transformed every $5,000 worth of shares into $65,000. This is the power of ‘10-bagger’ companies. Where will the next one come from? Read Greg Canavan’s special Crisis & Opportunity presentation to find out…(more)


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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