The cheap oil has drawn attention of a lot of investors. Many of you including me think that an oil price of 30-35 USD is just a temporary dive and in few months an investment in oil will yield considerable profits. Commodity investments are not that easy as they can look like though.

Consider this: When we buy stocks, either directly or through cheap ETF, we can kick back and wait until everyone else is going to see value of them and the price will fly high. The commodity investment, however, has an additional factor that affects market heavily – contango.

Contango – what is it?

To secure their revenues oil producers hedge their product. In other words, they sell oil contracts to be delivered in one year’s time. If the price of oil is around 100 USD producers ‘short’ oil for an amount equal to a production. If oil price drops down to 80 USD their revenue will fall but it will be compensated by the profit made from the future contracts because as we know the ‘short selling’ is making money when the price is declining.

Let us continue with our examples and set the price at 120 USD. Then revenues of oil producers rise but money made on futures will fall. As you can see in both examples total revenues stay the same as oil would cost 100 USD, independently from the actual change in price. The above method is used to supply nearly 70% of oil and gas sales.

This system was working pretty well with a steady oil price. Today majority of futures with 100 USD price tag have already expired.

If we choose a long position our contract will yield profits when price is going up. Most investors and oil producers believe that oil price in a year will be higher than it is right now. This results in futures with delivery date in 2017 costing not 33 USD (today’s price) but 41 USD.

Oil futures prices are more expensive than the spot price. This is what we call contango.

Low, 2-3% contango is a normal, naturally occurring phenomenon. Logically if we want to buy a product in the future a seller needs to store goods and insure them till this moment. This costs money. On the other hand, seeing contango at 20-30% is unnatural and stems from oil and gas price being very low.

Now we can see that when it comes to industrial commodities contango equals 1.8%, agricultural commodities 3.7% but for energy it can peak at astronomical 30%.

Coming back to oil, investing today in oil futures delivered in one year’s time we have to pay 41.5 USD. Spot price of oil stands at 33 .3 USD. Unless price reaches 41.5 USD we are bound to lose money. Only if the price breaks 41.5 USD we make profit.

The smallest contract requires a buyer to acquire 1000 barrels. We open a position worth 41 000 USD. This amount of money is basically ‘too much’ for a majority of people. If we don’t have this kind of capital we can still use funds like the ETC yielding profits whenever the oil price rises. Another example is a contract for difference – CFD. Here the problem lies in a time frame it uses – only 1-2 months ahead. When contract closes we need to buy a new one etc. A repetitive rolling of contracts generates costs and pushes the breakeven point further into the future. The ETNs are similar in this aspect, most of them also roll contract every month making contango even higher.

Summary

As you can see for yourself, commodity investments are far from being a piece of cake. It does not matter that we can predict the price trend because it can be lower than contango which would put us in the red. Keep this in mind before you will binge on investments in black gold. I keep in my portfolio NOK and CAD that are two currencies strongly correlated with an oil price. I also have some Gazprom’s shares but apart from oil these are dependent on a general situation in stock markets. You can’t have it both ways.

 

Trader21