Tuesday, May 27, 2008

Is Contango Unusual?

And if so, why?

This guy says oil futures curves are usually in backwardation, meaning the further out in the future you go, the cheaper the futures price. Now I don't know--I haven't actually looked at a lot of forward curves. But this doesn't make sense to me. I can see how seasonal variations might create backwardation--so, for example, if oil usage is higher in the summer than in the winter by a factor greater than the risk free interest rate and the storage yield, then you could expect a state of backwardation. Maybe that is what Hussman is talking about. (Nymex actually has crude in a state of backwardation for the year--July crude settled at $128.85/bbl, and December crude at $128.67/bbl.)

But if you factor out the seasonal effects, it seems to me that crude (and all commodities) should generally be in contango--i.e., the futures curve should be pointing up. The reason is that if you created an artificial future by borrowing money at the loweest rate possible--LIBOR, say--and bought crude at the current spot price, and stored it in a tank farm (again at the lowest storage rate possible), the future value of your oil, assuming there were no fluctuations in the market, would be the spot price plus the interest you pay plus the storage you pay for--which necessarily is more than the spot price.

Now commodities have this additional thing called convenience yield. This is the expectation of shortage in the future--in other words, the convenience of holding oil now versus having a contract to buy it in the future. Convenience yield would tend to push forward prices downward, so maybe they are what accounts for Hussman's assertion that oil markets are usually in backwardation.

I don't know. But I want to! Do any of my four or five readers have any experience here?

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