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Looking for a floor in oil markets? Check the contango
By Reuters | 12 Dec, 2014, 10.51AM IST

NEW YORK: Oil traders searching frantically for an end to the deepest price rout since the 2008 financial crisis should forget about OPEC policy, US drilling rigs or interest rates. At least for the moment.

Instead, according to some physical traders and analysts, they should be scouring their screens for what is likely to be the best leading indicator of a price floor: a deep contango, a market in which immediate delivery prices are cheaper - much cheaper - than futures in the months ahead.

When the discounts for prompt crude become large enough, traders can make money by buying crude to put into storage, which would finally give the market some support. The contango is not there yet, traders say, but it's close.

For storing crude onshore in Cushing, Oklahoma, the US oil hub, traders are looking for spreads of more than 30 cents per month for at least six months to pay for oil tank leases and financing costs, according to several market sources. The contango currently sits at around 20-30 cents per month.

"You don't need to have lower flat prices in order for that (a storage play) to happen, you just need steeper contango," said Michael Cohen at Barclays.

Picking a bottom in a crude market that has nearly halved since June has become a fraught enterprise, with prices probing new lows on a nearly daily basis in recent weeks. Analysts at Macquarie Bank said on Thursday that there was no longer any "analytically defensive floor" for prices.

Saudi Arabia says it has given up, for now, any effort to defend a floor for prices through cutting production, instead waiting for the market to fix itself. OPEC estimates a supply glut of around 1.83 million barrels per day in the first half of next year.

US shale drillers are likely to be the quickest to respond to lower revenues by throttling back output, but it will be months before production growth begins to slow, analysts say.

On Thursday, January US crude slipped below the $59 a barrel mark for the first time since 2009; Brent traded under $65 a barrel, down from $115 in June.

Enter the contango, a structure that provides the financial incentive to buy oil, if only to store it. Refiners and physical traders can buy discounted oil now, store it for a while and sell it at a higher price down the road.

"For this market to reverse, we'll need to go to the point of most pain," said one trading source who works for a refining company. "We're not there yet."

In late 2008, as the economic crisis sapped global fuel demand, US crude collapsed into a deep contango, falling to more than $8 from $1. At the same time, crude oil prices that had reached a record $145 a barrel found a floor around $35 a barrel. This triggered a more than doubling of stored oil to near 35 million barrels at Cushing.

A similar phenomenon could emerge soon, analysts say. Cushing stocks have risen over the past two months from near-minimum levels to around 25 million barrels, US data show, but remain low by recent standards.

The 2008 contango was so deep it sparked demand for tankers to use as storage facilities for low-cost crude. For such a lucrative ploy, a deeper contango would be needed than what the market is experiencing now.

The contango isn't "anywhere near" the level needed to spur floating storage trades, said Ian Taylor, the top executive at Vitol, one of the world's biggest oil traders, at the Platts Global Energy Outlook Forum on Thursday.

To be sure, other factors are also in play that may presage an end to the oil price rout - or at least a pause.

Technical and psychological factors are likely already playing a role. After US crude fell below the $60 a barrel milestone on Thursday, experts are looking to $58.32 a barrel as another watershed, oil's intra-day low from July 2009.

Some have also pointed out that break-even costs for drillers could be a good indicator, with broad estimates for profitability in major US shale plays ranging from $40 to $70.

However, a host of factors cloud those estimates, from heavy hedging that will safeguard smaller independents' profits through next year to the complexity of widely varied drilling economics in each shale play.

Anthony Starkey, manager of the oil analytics team at Bentek Energy in Denver, reasoned that the market is close to a bottom by the fact that some US producers are reconsidering or scaling back their capital investments next year.

"I think these are signs that we're nearing the bottom," he said. "The cutbacks in capex will lead to production cuts."

http://economictimes.indiatimes.com/markets/commodities/looking-for-a-floor-in-oil-markets-check-the-contango/articleshow/45489620.cms?prtpage=1