— John Kemp is a Reuters columnist. The views expressed are his own —
By John Kemp
LONDON (Reuters) - Retail investors betting on a price rise in oil via exchange-traded funds and institutions using commodity indices are paying a steep price for going long too early. The cost of rolling positions forward in a contango market is wiping out any gains they are likely to make if prices eventually rally later this year or early 2010.
Contango is the term used to describe the situation in a futures market where prices for immediate or nearer delivery trade at a discount to those for future delivery.
In the meantime, the main beneficiaries are investment banks taking the opposite side of the trade to their customers, and physical traders able to store increasing amounts of crude and finance it by running a short position in the futures markets.
In effect, retail investors and pension funds are paying the bills for the record quantity of crude oil being stored in tank farms around the world and in vessels offshore, via the losses they make when they roll their positions forward every month.
The problem is that most retail investors and pension funds focus on the wrong set of prices. For the most part they concentrate on spot prices as reported in the media by the generic front-month price, which is simply the price for the futures contract nearest expiry. As each contract expires, it is seamlessly replaced by the next-nearest contract.
Spot prices have risen strongly in recent weeks as the market scents signs of economic recovery. They were $56.71 per barrel at the May 7 close, up $7.43 (15 percent) since the start of December 2008 ($49.28), creating a handsome return.
But in the real world, it is not possible to hold a generic contract. Each contract purchased by an investor matures on a specific date, for example Dec 2009 crude or June 2010. As the contract approaches expiry the investor must either take delivery or roll the position forward by selling the expiring contract and buying another with a longer maturity.
If the expiring contract and the forward are valued equally, there is no cost, besides brokers’ commissions and the bid-offer spread. But when the market is trading in a contango investors incur a loss on every roll, as they sell a less valuable contract to buy a more expensive one.
In the last 6 months, the cost of rolling a maturing futures position forward one month at a time in a contango market has typically exceeded $1 per month (at times more than $2).
The annualized roll cost of $12-24 has to be set against any eventual rise in the oil price. With most analysts forecasting a rise in prices to $65-$75 next year, the cost of rolling a long position forward for 12-18 months will wipe out the expected gain.
In fact, the crude market has settled into an equilibrium trading pattern in which the cost of the contango matches the anticipated increase in prices over the next 12-24 months.
The attached charts give some idea of the contango impact on investors' positions (here).
Future contracts are valued at a significant premium to the spot market. But as they approach maturity the premium erodes and contract value tends to fall, other things being equal.
So while spot prices are up 15 percent compared to December 2008, contracts for forward months like Aug 2009, Dec 2009 and June 2010 are essentially flat. As the forward premium erodes, providing no gain for investors holding them (charts 3 and 4).
An investor who bought the Aug 2009 contract back in December would have made only $1.50 or 2.6 percent of the purchase price based on Thursday’s closing prices.
The main beneficiary of these roll losses are those market participants running short positions, able to buy back their short at a lower price while simultaneously selling a contract further forward for a higher one and pocketing the difference.
In the current market, the shorts are mostly investment banks (taking the other side from their customers) as well as merchants and refiners (hedging large volumes of physical crude).
While retail customers and institutions pay the bills, much of the smart money remains short for the time being, waiting for stronger signs of an upturn, some of the excess inventory to start being worked off and the contango to narrow.
It is possible to avoid the roll cost by buying futures contracts much further into the future. But prices for contracts in Dec 2010 ($69) and Dec 2011 ($71) look expensive relative to market expectations of where prices might settle in the next two years and are not especially attractive on a risk-reward basis unless the crude market tightens significantly.
In futures markets, timing is everything. There will be a time for retail investors and pension funds to be long of crude oil futures — but not yet. Investors will pay a high price for going long too early.