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The Contango Trade: a Cost of Capital Competition by Lewis Hart

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The Contango Trade: a Cost of Capital Competition by Lewis Hart The Contango Trade: A Cost of Capital Competition By Lewis Hart Black Friday 2014: As crude oil prices began their precipitous descent from $100 per barrel (bbl.) to less than $50 per bbl., a specter of protracted gloom washed over oil producers across the globe. 8 Brown Brothers Harriman | COMMODITY MARKETS UPDATE Energy exploration and production (E&P) companies, which between today’s price for crude oil delivery compared with the future had been generating returns of more than 30% at $100 per bbl. price, also known as the time spread or the calendar spread. of crude oil, suddenly faced a murkier future. The pessimism afflicting the producer community was perhaps only surpassed Daily Global Production and Consumption by the optimism – or perhaps opportunism – that swept across 120 oil trading desks in places such as London, Houston, Geneva, and 110 . l 100 Singapore. Traders welcomed the sudden return of price volatility b b f o after nearly eight years of historically low levels. s 90 n o i l l i 80 M WTI and Brent Crude Spot Prices 70 WTI Brent $120 60 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 $110 1 9 9 9 9 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 $100 Reflects production and consumption of liquid fuels Production Consumption $90 (crude oil, lease condensates, natural gas plant liquids, other liquids, refinery processing gains, and alcohol) . l $80 b Source: DOE, EIA, Bloomberg and BBH Analysis b / D $70 S U $60 $50 $40 Term Structure of Crude Oil Prices $30 $20 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 As with interest rates, the “term structure” in commod- Source: Bloomberg and BBH Analysis ity prices refers to the relationship between prices for a given commodity for different delivery dates. When the market is in contango, the spot price of the commodity WTI Monthly Price Volatility is less than the future price. Conversely, when the mar- 30% ket is in backwardation, the spot price of the commodity 20% is greater than the futures price. The relationship among 10% prices at different points across the curve is generally a 0% function of supply and demand expectations. (10%) (20%) (30%) The glut of inventory caused the spot price of crude oil to decline 0 5 0 1 1 2 2 3 4 5 3 4 1 1 1 1 1 1 1 1 1 1 1 1 - - - - - - - - - - - - c c c c c n n n n n more rapidly than the forward price, resulting in an increase in e e e e e u u u u u Sep J J J J J D D D D Sep D the time spread. Traders who had secured long-term oil storage Source: DOE, EIA, Bloomberg and BBH Analysis capacity at low rates in advance of the crash through ownership of storage facilities or long-term leases with third-party operators Enter Contango were pleased to see the market dislocation. Similarly, storage If the price crash was unwelcome to the producer community, operators who had not leased all of their storage capacity could market participants down the supply chain were not complaining, suddenly consider raising the rent. particularly energy merchants, crude oil storage operators, and refineries. The arrival of price instability was particularly welcome by companies whose business models included exposure to one of the key profit drivers in the energy trading business: the difference October 2015 9 U.S. Crude Oil Cushing Stocks merchant could profitably purchase and carry crude, hedge the 70 price risk by selling a futures contract, and still earn a profit, much attention was given to the pure cost of term storage – particularly 60 floating storage held in offshore tankers – with less emphasis 50 placed on an even more important variable: the structure and . l b b cost of a merchant’s capital. f o s n 40 o i l l i M As capital providers and advisors to a number of energy 30 merchants, BBH received many inquiries from clients on financing contango trades during this period of price volatility. In this article, 20 we zero in on how a company’s cost of capital is a critical and often overlooked variable in determining whether a firm can profit 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 from periods of contango. Inventory stocks are measured as weekly ending inventory levels in Cushing, Oklahoma, and exclude strategic petroleum reserves. Source: DOE, EIA, Bloomberg and BBH Analysis The Carry Trade: A Crude Primer After two years of fairly flat and backwardated forward curves – The following variables must be considered when evaluating when the difference between the spot price and the 12-month whether it makes economic sense for a merchant to futures contract rarely exceeded $5 per bbl. – the forward curve enter into a contango or cash and carry trade: suddenly flipped into a condition known as contango, where the price for delivery in the future exceeded the price for delivery today by an above-average margin. Similar to the yield curve The Carry Formula in interest rates, the term structure of the crude oil market – where the price for future delivery of crude oil is set – can at 1. The crude oil futures price as traded on the exchange times present opportunities to earn profit with minimal risk for LESS companies that have the storage capacity – whether leased or owned – and the capital resources to take advantage of it. 2. The “cash” or “spot” price of a barrel of oil, which is the price for delivery today 12-Month Time Spread 3. The cost of transporting the oil to its storage location $15 4. The cost of storing the oil near an exchange deliverable location $10 Contango market 5. The cost of insuring the oil $5 6. The cost of financing the oil $0 = The Carry Profit or Loss ($5) Backwardated 12-month minus 1-month WTI spread market ($10) When the sum of variables 2 through 6, also known as the ($15) Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 carrying cost, is less than variable 1, a merchant can in theory earn Source: Bloomberg and BBH Analysis an arbitrage with virtually no risk by purchasing crude oil inventory today, placing it into a storage tank or offshore vessel, and selling As the market shifted into a steeper carry structure, popular media a futures contract. To help mitigate geographic basis risk, the outlets and research outfits covered the new pricing dynamic in storage must be located near an exchange. As such, given the depth. But as market observers evaluated whether an energy excess inventory in the marketplace, storing the crude oil for 10 Brown Brothers Harriman | COMMODITY MARKETS UPDATE future delivery to a refinery looked like a particularly interesting How Much Does Your Capital Cost? option for merchants with inventory and access to storage. Working Capital Budgeting If the universe of merchants that had secured fixed price What factors drive each of these variables? Variable 1 represents storage before the arrival of contango was limited, the number the price for future delivery at a specific location (Cushing, of companies within that universe that could take advantage of Oklahoma, in the case of the West Texas Intermediate futures the opportunity was limited even further. The key driver of this contract). Price formation occurs through trading activity on differentiation is rooted in a simple corporate finance concept the futures marketplace and is beyond the merchant’s control. known as the weighted average cost of capital (WACC). Similarly, the second variable is set through trading activity in the spot market. Variables 3 and 4 can vary slightly based on We have found that merchants often consider only their debt cost whether a merchant has secured contractual transportation of capital when evaluating whether it pays to allocate a scarce capacity (via rail, truck, or barge) and storage capacity in advance resource such as financial capital to a potentially low returning, at a predetermined rate. Moreover, the storage cost can differ albeit low risk, contango trade. Looking at the total carrying costs, among merchants based on whether the merchant owns or financing costs should be lower than storage costs. However, leases storage facilities, when the storage rate was locked in, financing costs are generally a function of balance sheet size and if the storage was leased for a period of time, and for how long other credit variables. As such, this element – variable 6 in the the lease rate was locked in. Variable 5, though not a major driver prior formula – tends to differ most among merchants and should of the economics, will generally be a function of a merchant’s establish the marginal cost of carry. scale in the marketplace. Given the low risk profile, contango deals can typically be Merchants without the benefit of pre-existing storage capacity funded with high leverage; indeed, the inventory price risk is secured before the arrival of contango would be out of luck. As hedged, the inventory insured, and the oil often stored in or the forward curve steepened after the crash, storage operators near an exchange deliverable location or very liquid market raised rates to meet increased demand to store excess inventory.
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