“Super Contango”

A puzzle for you:

Super Contango, by Kevin Drum: Normally, it costs more to buy a barrel of oil for delivery six months from now than it does to buy a barrel of oil today. After all, if you’re not going to take delivery of my oil until July, then I’m going to want the spot price of the oil plus the cost of storing it plus the cost of having to wait for my money. So maybe a barrel of oil that costs you $38 today will cost you $41 for delivery six months from now.

But instead of $41, what if the July price is $53? Then anyone who wants to can make a guaranteed killing. Accept the contract, buy a tankerful of oil, store it for six months, and then deliver it.  Even after the cost of storage and the interest on the loan you took out to buy the oil, you’ll make a quick and easy … profit.

Sounds nice, but since this profit opportunity is so obvious it should get arbitraged away almost instantly. In short, a situation like this should never happen — certainly not for long periods, anyway. But it has…

So what’s going on? One possible explanation is that most of the easy storage is already full, so it’s not really possible to make a quick buck on this even if you want to. But even if that’s the case, there’s yet another option: oil producers can pump less oil now (essentially “storing” it in the ground) and then pump it out in July for delivery at the higher price. But apparently they’re not doing that. John Hempton figures there are two possible explanations: (1) they’re already pumping at full capacity, so they can’t promise to pump extra oil in July even if they want to, or (2) oil producers are so desperate for cash that they’re willing to take money now even if it’s way less than they could get for the same stuff six months from now.

#1 doesn’t seem to be true. So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now. Either that or else there’s an option #3 that’s not obvious. Any ideas?

Originally published at the Economist’s View reproduced here with the author’s permission.

One Response to "“Super Contango”"

  1. aciduzzu   January 14, 2009 at 9:18 pm

    if you are an oil producer 6 months from now you are going to pump an amount of oil independent of how much you pump today. ( the deposit is not going to dry out this year anyhow …:) ) so why not pump more today , especially since you are not into game theory