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Oil Price Faces Another 20% Drop Due To Contango Math

March 9, 2015

Oil Price Faces Another 20% Drop Due To Contango Math

Want to know where oil prices are headed? You need to understand the economics of the floating storage play, Soc Gen says. 

As we noted on Friday, retail investors looking to be the next Jed Clampett have piled into the U.S. Oil fund over the past several months, presumably unaware of the extreme contango in the market. That said, it’s not just retail investors who are itching to dive in. Here’s Soc Gen:

The motivation to buy it [is] widespread and not always based on traditional market analysis – consumers [are] keen to lock in lower prices with their newly expanded credit lines, due to the decline in the notional value of their existing hedges. Endowments and Sovereign Wealth Funds (SWFs) [are] under pressure to use the “opportunity” to claw back recent losses.

For those looking to make a play near the bottom, it’s worth considering the level at which the oil storage trade becomes profitable. At its core, the trade is simple:

A trader buys physical oil now at a low price, and simultaneously sells paper forward at a high price, thus locking in a profit margin. If this profit margin is higher than the cost of fixing a vessel to store it on, the trade works, and it should happen.

Although, as Reuters notes, “the capacity of U.S. commercial oil storage tanks has expanded by a third since 2010,” the global stock increase is set to be nearly 3 times bigger than during the last oversupply period (in the aftermath of the crisis). Given that floating storage was used in 2008-2009, it’s likely that cheaper on-land storage capacity will dwindle necessitating the use of crude carriers this time around as well. And with that, here is your step-by-step guide to the floating storage play courtesy of Soc Gen:

…click on the above link to read the rest of the article…

 

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