Profit Taking, Reduced Contango Suggests Oil Prices Could Stabilize

The last three months have seen a remarkable oil rally that has doubled the price of oil from around $35 a barrel earlier this year, to nearly $70 today. During this bull run however, there has been one nagging thought spoiling the fun of the traders cashing in on this rise – there is no real reason for oil prices to have climbed so high, so quickly. Demand has not suddenly shot up and the economies of the major oil consumers have not improved significantly, so why the price increase?

In reality, the market is oversupplied with oil. Yes, OPEC reduced production but only nominally and US oil and gasoline reserves have not been this high in years, so again, why the increase?

Obviously, traders are banking on a quicker-than-expected recovery and are pricing this optimism into the market, but there are two factors that could soon stall oil’s climb – a strengthening US dollar and a reduction in the oil contango trade.

When the US dollar is under pressure, gold and oil are usually the recipients of extra demand as investors often turn to these two commodities to hedge a falling US dollar. Today, the US dollar bounced back after several days of losses to hit a one-week high against the euro following last Friday’s unemployment numbers suggesting that the US is now losing jobs at a slower pace. This, together with other hopeful signs that the US may be making its first tentative steps towards a recovery, is boosting the dollar, and if the greenback’s recent resurgence proves to be a trend, it will surely reclaim some of the investment dollars currently parked in oil futures.

The other factor that will immediately affect oil prices is a reduction in the attractiveness of a contango strategy. Contango occurs when the price for a future delivery is higher than the current spot price, and when this difference is wide enough, trading firms will take on the added expense of storing commodities and release them to the market at a later date to take advantage of the increase offered by the future price. This has been the case with oil prices since the beginning of the year and several large trading firms have rented super-sized oil tankers, filled them with oil at the spot price, and then simply anchored the ships offshore to wait for a higher price in the future.

Storing oil in this manner may be falling out of favor however, and a report last Thursday confirmed that the number of supertankers presently storing crude dropped last month from 24 to 16. The timing of this move is revealing as it suggests that traders sitting on millions of barrels of crude now believe that the gap between the spot price and the future price is not going to increase significantly – or may actually narrow – making contango trades less profitable.

Bringing all this extra oil to the market and closing out these contango positions could prove to be tricky though, as a sudden increase in supplies will surely weaken oil prices. While a return to $35 a barrel is not in the cards, the actions of these traders does suggest that they believe crude prices will likely remain stable for the next few months. If they believed that the price of crude was still on track to climb at its current pace, they would gladly continue paying the fees to rent the tankers and hold out for a bigger payout.