Contango: What the Demand Bellweather is Saying About Crude

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The tango has long been known as the dance of love. Around the NYMEX trading ring, the ‘tango-the locals' shorthand for contango-has as many lovers as detractors. Contango is the pricing phenomenon characterized by successively higher back-month prices. For example, a $2.98 contango was evident on Friday when October 2010 WTI crude oil finished at $75.17 a barrel, and January 2011 crude settled at $78.15.

Contango reflects the carrying charges borne by owners of storable commodities like oil. If oil's to be held for future delivery-say in January-then the inventory must be financed, storage charges must be paid and insurance fees remitted. The oil market's contango denotes more-than-adequate current supplies. By this measure, there's been a relative glut of crude since June 2008 when the WTI market flipped from backwardation-higher prices for front-month deliveries-to contango. That pretty much presaged the recession in which we're currently mired.

You can see the relationship of the WTI price structure to domestic crude inventories here:

 

U.S. Commercial Crude Oil Inventories Vs. Three-Month WTI Futures Spread

 

Over the past two years, the three-month WTI contango has wobbled a lot, but has averaged $3.11 a barrel. That's hurt a lot of investors in long-only oil portfolios such as the United States Oil Fund (NYSE: USO). Contango is a recurring cost to this fund whenever it rolls an expiring long position forward. That expense is borne on top of whatever spot oil return is attained.

Here's the case in point: The front-month NYMEX WTI contract price has dipped 7.8 percent since the top of the year. USO-which invests in the front-month delivery-has slid 16.6 percent.

The sponsor of the USO fund recognized the deleterious effect of contango a while back and launched the United States 12-Month Oil Fund (NYSE: USL) in response. USL, instead of relying solely upon the nearby contract, obtains its exposure by investing in the nearest 12 WTI delivery months. By spreading the exposure over the oil term structure, its year-to-date loss has been just 10 percent.

So why bring all this up? Well, the WTI market's contango has been widening as summer has wound down. Back on July 20, the three-month spread was only 95 cents a barrel. Friday's contango is within spitting distance of the spread's average that's prevailed since June 2008.

Another way to gauge contango is to look at the spread between USO's and USL's share prices.

The chart below lays it out. As market participants suffered through their New Year's hangovers in January, the spread was about a buck in USL's favor. When contango peaked in mid-May at $8.30 a barrel, the spread had widened to nearly $4 a share.

After that, a funny thing happened. Contango shrunk-a lot. But the USL-USO spread? Not so much. It turns out that USL has a memory! Which only seems logical when you consider what and how it rolls its positions forward.

 

WTI Contango Vs. USL-USO Spread

 

The point of all this is that the oil market contango (or inversion) is a bellwether of broader aggregate demand. Widening denotes a backup of supply, typical of economic slowdowns. Inversion implies demand in excess of current supply (over the past 25 years, in fact, the WTI market has exhibited a small average inversion).

The USL-USO spread provides a similar signal, but also supplies a decision point for those wanting long oil exposure. Investors seeking less portfolio volatility might do better with USL than USO in times like these.