- The price of crude oil is extremely attractive now, but buy it is still too dangerous.
- Time works against us in the form of contango.
- We either have to wait or we can buy oil stocks instead of crude.
- Familiarize yourself with the concepts of contango and backwardation, they happen regularly by all commodities.
Very Attractive Crude Price Level
Many small investors are now interested in crude oil buying speculation as prices literally collapsed in March. After the unsuccessful OPEC-meeting, the press wrote about a Saudi-Arabian-Russian price war. WTI Crude crashed from around $60 at the beginning of the year 2020 to $20 and some below. That is a 19-year record level, approximately. The heavily discounted crude price is attractive because the price of oil has made big bounces in the past. (For example, in 2016-2017, or 2009.)
Last week, U.S. President Donald Trump put pressure on the parties to agree to cut oil production. At the time of writing, it is not known whether this will be achieved. And if so, whether it will be effective. Oil consumption in April could be 23 percent lower than a year earlier (by the prognosis of Rystad Energy). Meanwhile, production by major producers has even increased a lot recently.
Two Main Dangers for Crude Buys
The entire world is facing severe economic depression because of coronavirus. We can’t say on which level the price of crude oil will be tomorrow or next month. Perhaps very high, maybe very low. But it is very important to draw attention now to some dangers that threaten investors who speculate on oil. And the phenomena to discuss in this article are common to most other commodities, too. Also, for example, the futures contracts of the VIX, an index that measures the volatility of the S&P 500 stock index.
Cheap oil offers a great opportunity, but also means a lot of danger. The very first one may be the global depression. If the coronavirus pandemics cause a deep and very long recession and oil producers don’t cut their output, the prices can fall much further. And for a long time. Oil storage capacities are almost full already.
What Means Contango for Oil Buys?
But the phenomenon of contango signifies a similar huge danger for oil buyers now. Contango means that the closer settlement prices are lower than the more distant ones. So, if we buy crude futures and the price does not rise quickly, we can only re-enter the position at a higher price later. That causes a continuous loss for crude oil buying investors. Nearby futures positions need to be renewed every month as they expire (run out).
If you buy the nearest month’s futures (for example, WTI Crude Oil, May), it expires in less than a month. You have to buy another product, for example, the next one, June, to hold your long (buying) position. With contango, this next month’s product will have a higher price. Over time, with contango, the prices are, in general, slowly decreasing, nearing their expiration.
See the chart of a theoretical investment in strong contango, where the futures price is initially $20, and that is declining slowly to 18. What happens here is, the long position holder has to buy the commodity every month for $20. Every month, the price plummets to $18, and the investor loses 10%. Buys for $20 again, expires at $18, etc. A terrible investment, buying high and selling low every month. Whilst the spot price of the product doesn’t change at all.
This Is a Supercontango
In the next picture of a Barchart.com table, an actual example of last WTI crude oil prices. The percentage value of the contango (June/May) is by nine percent. But in the last weeks, this contango, the difference of the next two WTI Crude futures reached, sometimes, 15-20 percent. A month. Some experts are talking about a “supercontango”. An unusually high contango that can’t be explained by the interests and storage costs.
How Can You Avoid Contango Losses?
How can you avoid losses caused by contango as a crude oil buyer? Easy: Don’t buy it. It is too dangerous. It is only for professional and short term players, for now. Don’t buy and hold crude futures – or any futures – in times of high contango. (And don’t short futures in case of high backwardation, see later.) You can buy crude oil if contango is low or doesn’t exist.
If you want to take advantage of cheap oil, it can be better to buy shares of oil companies. These, too, have plummeted in recent weeks along with oil prices. If the oil recovers, their price will also rise, at least it is probable. Here, even significant dividends are expected of them. If you have to wait a long time for these stocks to recover, because the crisis stays here for a long time, at least you don’t have to pay the losses of contango. There are also a lot of ETF-s (Exchange-Traded Funds) on the US and European stock markets containing oil companies (like FILL, XOP, XLE, etc.)
Special Risks of Oil Giants
Oil companies also have special risks. Some stocks follow the price of crude closely, some only roughly. Each company has unique characteristics and problems, such as political risks depending on the locations of oil extraction. There may be environmental disasters like a major shipwreck and oil spill. Many companies are not only oil producers but also have transportation, refining, retail capacities. Are dealing with natural gas or other raw materials. But this may not always be a problem, as the risk is better shared across several sectors. (The portfolio is more diversified.)
If the crisis persists, some companies could go bankrupt. It is also possible that after this crisis consumer habits will change. People will work more in home-office, travel less, and consume more nearby produced products. This reduces the demand for traffic, transportation, and oil. Because of climate change, governments may tax energy companies even more on the pretext of protecting the environment. In the long run, oil demand could also fall much further because of the rise of electric vehicles.
The Crude Example of 2015-2017
Chart 2 shows you the contango and backwardation of WTI crude oil in the last six years. (Data over the red line: state of contango, below the line: backwardation.) In 2015-2017, there was a long period of contango, for almost three years. I show you a special example of the longer-term effects of the contango. In Chart 3, you can observe the price of Texas crude oil futures (CL1), the long crude USO ETN (Exchange Traded Note), and a crude short ETN (SOIL). Also two oil companies’ stock ETN-s, FILL (global firms) and XOP (US oil producers).
The result of these almost three years is interesting. Crude itself fell 18.5 percent in this period. But the USO long oil ETN (Exchange Traded Note), much more, 57.6 percent. It was a disastrous investment, frankly. But only a small part of this was caused by the expenses. In big part, it was the contango. At the same time, the crude short-seller ETN, with the ticker code SOIL in London, surged 48.6 percent. More than double of the fall of the futures price itself. (It is not leveraged.) For short-sellers, contango can be a blessing.
Oil Stocks And Dividends
The global oil multinational companies’ ETF FILL fell only 10.4 percent on the chart. In reality, almost nothing, because the fund also paid dividends. The dividend yield was approximately three percent in 2015, 2016, and 2017. The US oil company ETF, XOP, was 35 percent down and paid less dividends (With yields 1.9, 0.9 and 0.8 percent, approximately, projected on the exchange rate.) But many American companies were and are much more vulnerable than huge multinationals. The shale oil (fracking) entrepreneurs often work with a significant loan portfolio, high leverage.
The opposite of Contango, the Backwardation
The opposite of contango (or forwardation) is called backwardation.
Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. (Investopedia)
Backwardation is when the current (spot) price of an underlying asset is higher than prices trading in the futures market. Backwardation can occur as a result of a higher demand for an asset currently than the contracts maturing in the future through the futures market. (Investopedia)
Contango is bad for buyers, i.e. investors sitting in long positions. But it is favorable for those who shorten the given product, who have a selling position. Backwardation works the other way. It is favorable for buyers (long positions) but produces a steady loss for short-sellers. By backwardation, buyers buy low and sell higher. By contango, sellers sell high and buy it back lower, cheaper. (See Chart 1 above and Chart 4 below.)
But this is only true if the main price level of the given commodity doesn’t change too much. If you are earning as a short seller with contango, but the price of the commodity explodes, you can lose much more than the contango. The time factor and the direction of the market are other important elements that affect the success of your investment.
Conclusion – Which Buy Is Better?
As you have seen in the example of USO in 2015-2017, being long in crude oil can be a terrible business in times of contango. Shorting it can be successful, also, if prices don’t move so much but contango persists. But shorting is very dangerous. For example, oil producers can limit production and price can explode. Also an economic recovery, higher demand can send prices upstairs. Oil company stocks? Sounds much better. It depends on the stocks, on the companies in different situations.
What you have learned about oil contango and backwardation is useful with any other commodity. Most of them are almost always in contango or backwardation.
Update: Don’t Buy USO, Short USO
On one of my favorite investing websites, SeekingAlpha, HFI Research wrote a similar post like this one about crude oil buy. In a part about the problem of supercontango. Inventories in Cushing (Texas) will “hit tanktop” soon, which can push crude oil prices even lower. Their actual trade idea is “looking at shorting USO”.
“A lot of people are buying USO to bet on a rebound in oil price. That’s the wrong vehicle to do it in” – so HFI Research. “You are getting a really bad deal being long USO, but you might make more by betting against USO. There are alternatives like energy stocks and MLPs that investors can bet on higher oil prices” – wrote the post, similar to our article.
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I’m not a certified financial advisor nor a certified financial analyst, accountant nor lawyer. The contents on my site and in my posts are for informational and entertainment purposes and reflecting my collection of data, ideas, opinions. Please, make your proper research or consult your advisors before making any investment or financial or legal decisions.
I have open positions in global energy companies stocks (long) and crude oil (short) at the time of writing.