What is Contango?
It’s no secret that oil is cheap right now (really cheap). But what happens if oil is too cheap? Investors and consumers are capitalizing on the historically low price of oil by purchasing record amounts of it to store—then to be sold when the price inevitably rebounds. The only problem: when there’s that much oil in circulation, the world starts to run out of room to store it.
This is Contango. When a commodity is oversupplied and isn’t being consumed as quickly as it’s being produced, some of the purchased goods must be stored for later use. Those buying oversupplied oil must pay for the cost of storing it until the date it is either used or sold. This storage cost drives up the future price of a commodity, above the current market price. Essentially, buying oil to use or sell three months from now costs more than buying it to use right now. Currently, the price of Brent crude oil for June costs $1 more than it does in May.
The Cause of Contango
The low price of oil has caused some lower capacity oil projects to close, and those that have been able to keep their pumps going have needed to further increase production to remain profitable. As a result, global oil inventories have hit successive 80-year highs in recent weeks.
This current global oil oversupply is predicted to be larger than the last time oil was in contango from 2008 to 2009. Not only is this current contango a result of an increase in US oil production, but an opening of more transit pathways and storage facilities for American oil. The openings of massive storage facilities in the American midwest have allowed more North American oil to be easily and cheaply stored for later transportation to international markets.
In Cushing, Oklahoma—the largest oil hub in the U.S.—the amount of oil in storage has more than tripled in four years, from 15 million barrels in September 2008 to 47 million by summer 2012. Even with this increase in capacity, analysts say that if the current surge in the availability of oil continues, excess storage space will quickly be occupied. Though the outlook for oil demand is weakening, in 2015, US oil output has been steadily increasing by 1 million barrels per week. If this trend continues, experts are projecting that 80% of Cushing’s capacity will be hit around mid-April.
Oil Contango: Supply Chain
As storage space for crude oil begins to run out, oil holders start looking for more unconventional or ideal places to store excess oil. Where this oil ends up, and how it gets there, can have both positive and negative effects on the global supply chain.
One strategy oil holders begin to look at when on shore storage space begins to fill up is using off shore oil tankers. Over the past several months, shipowners have been hesitant to take calls from oil companies looking to lease their vessels, given seasonal hikes in freight rates. As the rates die down, freight companies are likely to be more open to lock in oil storage rates, rather than dealing with unpredictable freight rates. This could ultimately lead to a shortage in available container ships, potentially catalyzing an increase in freight rates.
Unfortunately for sea based storage tankers, the dramatic increase in the global oil supply isn’t generating as much demand as anticipated. Land based storage facilities expanded more rapidly than initially anticipated by analysts, dramatically reducing the need for offshore storage solutions. Oslo based investment bank RS Platou Markets reported last week that the industry’s largest storage tankers are earning 23% less per day than previously estimated. While this is bad news for companies looking to bring in some extra storage cash, in the short term, unneeded storage space frees up previously committed vessels to compete for freight charter work.
US rail freight rates may also see a dramatic increase, as the number of carloads of crude oil being handled to and from these storage facilities skyrockets. In 2008, US freight railroads delivered 9,500 carloads of crude oil. In 2013, they delivered 435,000—a 4,400% increase. This dramatic increase in volume has lead to an increase in stress put on the US freight rail system. As the number of carloads handled every day continues to grow, expect freight rates to increase as well.
The Bottom Line
ExxonMobil predicted in its global energy report released earlier this year that demand for oil will be increase by 35% by 2040. High levels of future demand may begin to mitigate the dramatic oversupply of oil and assuage anxiety surrounding global oil storage capacity. For months, analysts have been waiting to see which will happen first: running out of physical storage space as the supply of excess oil grows, or a decline in production as the US oil rig count falls and new projects are cancelled. If the former outpaces the latter, the world oil supply could be headed towards a super contango, wherein the future price of oil is far higher than the current spot price. In that case, expect the cost of freight shipping to increase as more ship owners opt to store oil instead of moving freight. If a decline in oil production occurs in time to lessen fears of running out of storage space for crude oil, then the contango and its effects will begin to dissipate and freight rates should stabilize.
The low price of oil ostensibly has positive implications for supply chains—low oil prices imply lower shipping and logistics costs. The unfortunate reality may be that the increase in oil production that accompanies these lower prices will result in a net loss for supply chains.