In a continuation of yesterday’s post, It Takes Two (Months) to Contango, I want to focus a little more on the roll. The roll is what an investor, or speculator, in the futures market needs to do to keep their investment open and avoid taking delivery of the commodity in question. Remember, futures are an obligation to buy or sell a commodity at a certain price on the day the contract expires. If you don’t close the futures contract before it expires, you can expect a big truck to unload 1,000 barrels of oil on your lawn in a few days. Unless you’re running an oil refinery, this is not a good move.
Before expiration, investors betting on a commodity need to sell the contract for next month and buy the contract for the second month out. When the first month expires, the second month contract, becomes the new first month contract. Yesterday’s post dealt with the cost involved with the roll and how when the price of oil is rising, a trend called “contango,” you will earn less than the total movement in the spot price of the commodity. However, unless you want to take delivery, this is the closest way to play the spot price.
Last week I highlighted an article in the Wall Street Journal. It said the U.S. Oil Fund (USO), the exchange-traded product that is a pure play on the first month oil futures contract, is getting so large it’s affecting the oil market. The Journal writer Carolyn Cui says the $3.3 billion in assets held by USO accounts for 22% of the outstanding front-month contracts. According to Cui the fund is so large that on the day it moved from the March to the April contract, Feb. 6, it had a visible affect on the oil market.
I called John Hyland, the portfolio manager of the U.S. Oil Fund, to get his take on this. Hyland says you can’t blame a huge one-day move solely on USO without looking at the trend three days before the roll and three days after.
“The people who look just at the day we roll and say the spread was “X”, that doesn’t tell you anything,” says Hyland. “You have to look at the days leading up to and the days after. You might miss the trend going on if you just look at USO.”
For instance, if the three days before the roll, the spread on the contract was $1 and the day of the roll the spread jumped to $2, then you can say there was an affect.
According to Hyland, the three days before Feb. 6, when USO rolled over its contract, the spread between the March and April contracts were $3.99, $3.87 and $3.88. The day USO rolled it jumped to $4.55. However, the next day the spread grew to $4.76 and over the next few days jumped to $4.81, $5.24 and $6.06, eventually widening to $8.19.
“The spread is tending to move wider as you get into the middle of the month, as March gets closer to expiration. Is that USO’s doing? How are we doing it after our roll?” asks Hyland. “It looks to me that as we get closer to expiration, it’s more of an inventory issue. The people who say it must be USO are not really looking at everything.”
Inventories are rising. If demand for oil drops off a million barrels a day and OPEC produces the same amount of oil, then inventory goes up million barrels a day. A lot of oil in the tanks is not bullish for the March contract. With supply rising and inventories hitting 52-week highs, one would expect the oil price to weaken. If OPEC cuts production, the shortfall will be made up from the current inventory. As inventories get smaller, the front month contract will stop trading at a big discount to the contracts further out.
People are assuming inventories will not build up indefinitely. OPEC will have to reduce production, if for no other reason than they will run out of storage tanks. Since the cheapest place to store oil is in the ground before you pump it out, they will cut production. At that time, inventories will start to shrink.
Market Folly, the blog posting I ragged on yesterday, actually has an interesting slide presentation from the International Energy Agency from November called The Era of Cheap Oil is Over. It’s a good read for anyone investing in oil.