Pssst! Wanna make a bunch of money with futures? Naw, this ain’t no fancy-schmancy trading system. This is locked-in profit — no risk, zip, zero, goose egg. Ya see, we buy Brent crude for delivery this January at $42.40 (US) a barrel, then sell the August 2010 contracts at $61.05. We make a guaranteed return of 44 percent in a year and a half. Can’t lose!
Ah, doesn’t that mean you have to store the oil?
Riiiiigghhhht. That’s where you come in, see? Can I use your basement?
In a year jam-packed with extremes, the wacky oil market fits perfectly. Generally, prices for commodities futures in the longer term are a bit higher than for the near term, a condition known as contango. Mild contango simply takes into account inflation and the likelihood that the price for the commodity will increase somewhat over the intervening period.
Sometimes, temporary shortages cause near-term delivery prices to be higher than those further off, known as backwardation. Indeed, this was the case during the height of the commodity boom, when the futures market strongly indicated that $140-a-barrel oil would not last and prices would come down.
But contango on the current scale is rare, and reflects a market that is stressed to the point of psychosis. As everyone knows, the price of oil has crashed, but traders now argue over whether the hefty contango is due to a fleeting supply glut or the perception that the economy and demand for oil will bounce back later next year.
We Contra Guys have no intention of speculating in oil futures; nor do we plan to rent a supertanker to store oil in the Gulf of Mexico, as some companies are doing. However, the futures market can be a useful tool for investors who are looking for clues about how the economic crisis will play out.
For starters, it adds an interesting complexion to the context for evaluating oil producers. Those that have strong balance sheets and don’t have to sell all their production immediately to pay interest have the advantage of being able to hold back and sell next year at much higher prices.
Petro-Canada, Royal Dutch Shell and Imperial Oil all appear to fit into that category. Those that are leveraged to the hilt, or trusts with very high payout ratios, won’t have that luxury.
But does the steep contango tell us anything about the big picture? There is strong contango for foodstuffs such as coffee, orange juice and sugar. Also for basics like cotton and lumber. Obviously, these commodities are difficult to store, so taking advantage of higher future prices is impractical, but taken together, these conditions don’t seem to support the deflationary scenario that some commentators are painting.
Rather, they suggest that, once this crisis wanes, all the old exigencies for resources on a crowded planet will re-emerge and the prices of goods that don’t come off a silicon assembly line in Taiwan will once again rise. And with the amount of money that has been printed lately, there will be plenty of paper to chase hard goods once sentiment tips back the other way.
Those cheap prices at the gas pump have brought welcome relief. The futures market is signalling that we shouldn’t get used to it.