HardAssetsInvestor

Written by Brad Zigler  |

November 26, 2008

Oil Guesses Wrong Again And A Worrying Contango

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Real-time Inflation Indicator (per annum): 7.9%

According to the U.S. Energy Department's weekly inventory report, domestic crude oil supplies increased 7.3 million barrels last week, far exceeding the forecast for a 900,000-barrel build made by Oil Patch analysts. Traders opened the NYMEX futures floor session 3.4% higher ahead of the report, following a 6.7% decline on Tuesday. The United States Oil Fund (AMEX: USO), an exchange-traded portfolio that tracks oil futures, fell $2.77 in lockstep to finish at $41.36.

The inventory spike marks the tenth consecutive weekly increase. Domestic crude oil stocks are now in the upper half of their average range for this time of year, according to the Energy Department.

Technically, the crude market is oversold, which hints of a possible short-covering rally, but upside resistance for the nearby NYMEX futures remains firmly entrenched at $59. Until futures can close above that level, the bears control oil’s pricing. The near-term downside objective is $46.

Oil patch prognosticators also called for refinery utilization to tick up 0.2% to 85.1%, but missed their target by a wide margin. Refineries instead operated at 86.2% of their capacity, increasing gasoline and distillate fuel production significantly.

The United States Gasoline Fund (AMEX: UGA) dropped $1 to $22.31 Tuesday, tracking the 4.6% decline in unleaded RBOB gasoline. Futures, however, opened 3.4% higher in New York ahead of the government’s inventory report. Insiders called for a 100,000-barrel build in gasoline stocks to augment the 539,000-barrel increase reported the previous week. Total motor gasoline inventories, however, increased by 1.9 million barrels, reflecting a 2.8% decrease in demand from year-ago levels.

Heating oil futures began the NYMEX floor session up 3.5% today. Forecasts of an 800,000-barrel decline in distillate stocks, including heating oil and diesel fuel, buoyed the market after heating oil futures closed off 4.6% Tuesday. The United States Heating Oil Fund (AMEX: UHN) sympathetically eased 60 cents to finish at $27.31.

Energy Department tallies, however, showed distillate fuel inventories slipping by only 200,000 barrels last week. Distillate fuel demand was clocked 2.2% lower than this time last year.

Yesterday’s large dip in crude feedstock prices had the salutary effect of improving refining margins. The nearby crack spread rose to $5.71 a barrel Tuesday, yielding an 11.2% margin. A week before, margins were only 5.9%. An explanation of the crack spread significance can be found in “Time For Crack Spreads.”

NYMEX Crack Spread-Derived Refining Margins

The build in petroleum complex inventories is being reflected in the relentless widening of the NYMEX crude oil contango. Contango prevails when future prices are higher than near-month prices. The reverse, known as backwardation—where nearby deliveries are priced higher than deferred futures—is more typical of a supply-compromised crude oil market.

The quarterly contango grew to $3.56 a barrel, or 6%, Tuesday, its widest level since the market slipped out of backwardation in June. Contango creates an incentive for producers and refiners to buy oil for near-term delivery and store it in inventory. As storage fills up, storage costs rise and the contango tends to widen, providing an investment return.

Crude Oil Contango/Backwardation Vs. Inventories

Many market observers warn that aggressive widening of the contango portends a sell-off. That’s ultimately true, but it can take a while.

A lesson can be learned from the past. The last time a contango was associated with a decline in oil prices was a decade ago. Back in 1998, the oil market was trapped in a cycle which constantly reinforced contango. Rising inventories were interpreted by market participants as oversupply which depressed spot prices, further widening the differential between future and nearby deliveries. That encouraged further inventory building and still more widening of the contango. Ultimately, the quarterly contango topped out above 19%. It took large production cuts by Venezuela, Mexico and Saudi Arabia to reign in the market.

In part, the volatility in the 1998 market was a pendulum swing from the drastic backwardation seen in two years before. Our current market’s antecedent backwardation pales in comparison. The current contango, too, is relatively modest so far. The current interest rate environment, however, makes 6% a mighty attractive quarterly return.