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Contango is structure in which the futures price of a commodity, such as oil, is higher than the current price, which incentivizes sellers to hold stocks in reserve. (JONATHAN HAYWARD/THE CANADIAN PRESS)
Contango is structure in which the futures price of a commodity, such as oil, is higher than the current price, which incentivizes sellers to hold stocks in reserve. (JONATHAN HAYWARD/THE CANADIAN PRESS)

Oil price ‘contango’ provides a risky investment opportunity Add to ...

While crude oil remains mired near 5 1/2-year lows, oil tanker stocks have been on a tear.

Early into 2015, Nordic American Tankers Ltd. and Teekay Tankers Ltd. are both up double digits, with Frontline Ltd.’s 30-per-cent advance far outpacing its peers.

That’s because there is now demand for massive tankers not to ship oil across the ocean, but just to sit there, fully loaded, to sell the product for a higher price in the future.

The market dynamic underpinning this development is contango, a market structure in which the futures price of a commodity, in this case, oil, is higher than the current spot price. The price of a barrel of West Texas intermediate remains below $50 (U.S.), but the 12-month futures contract allows sellers to realize a price close to $56 a barrel next year.

Reuters reports energy trading firms have begun to reserve oil tankers to take advantage of this opportunity. Daily rates charged by tanker companies have soared, but these aren’t an accurate depiction of the revenues the firms will generate from these deals. Because of the length of these contracts and the preference for storing it on older vessels, trading firms are able to book tankers at a considerable discount.

This “floating storage” was last in vogue in 2009, after oil prices had collapsed spectacularly and the global economy was mired in a recession. As the global economy recovered, however, shipping companies were in for a crude awakening: A growing U.S. economy didn’t spur a pick-up in demand for oil shipments from the Middle East, as the shale revolution and an increase in production from the Canadian oil sands displaced these imports.

And as Izabella Kaminska of FT Alphaville has noted, the economics of oil storage have changed dramatically thanks to this shale boom. A new play in the Eagle Ford region of Texas, for instance, is able to bring oil to the market far faster than, say, a new mine in Alberta, and has a much shorter life-cycle. If the futures price one to two years out can provide a positive return for a shale producer, it will be able to lock in that selling price and stands a fair chance of securing financing. As such, a contango structure that incentivizes storage can also serve as a boon to shale producers, and the two will be in competition for capital.

“In short, because the industry can bring new supply to market relatively quickly, we go from a spare capacity model, to a just-in-time model instead,” Ms. Kaminska writes.

Jeffrey Currie, head of commodities research at Goldman Sachs, suggests that the 12-month futures price must remain below $65 a barrel – his estimate for the marginal cost of production for shale producers – to meaningfully deter investment. But it’s no longer necessary to load ever-increasing amounts of oil onto tankers to protect against a shortage, because the responsiveness of shale production will keep such a market imbalance from persisting for a long period of time.

Fortunately for tanker companies, the current contango structure is a Goldilocks scenario: The one- to two-year future prices are low enough to discourage investment in shale, but high enough that trading firms are able to generate a return through storing oil on their vessels.

But in this industry, a favourable backdrop has fostered overoptimistic expectations of success down the road, with malinvestment leading to significant excess capacity that has long weighed on the daily rates companies are able to charge, increased indebtedness and dividend volatility. Frontline, the current darling in the space, had to issue 760,377 shares in late December to placate its creditors, a payment for its past sins.

This propensity for mismanagement is also what worries analysts about airlines: that they’ll show a lack of discipline in response to a massive decline in the price of their biggest operating expense.

These industries are seemingly among the biggest winners from the low-oil environment, but investors would do well to approach with caution. In both, there are few examples of sustainable success stories one can turn to: These are risky, short-term trades, and worth avoiding for those who wish to sleep soundly at night.

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Follow on Twitter: @ljkawa

 

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