January 10, 2007

Wither the Oil Price

Crude oil prices continue to fall amid cuts in Russian oil supplies, talk of cuts from OPEC, revolt in Nigeria, more nationalization in Venezuela, and a tinderbox in the Middle East.

What's driving the price of oil down? It must be the weather.

Well, that and an apparent exodus of investors and speculators.

In this story from CBS MarketWatch, at least one analyst doubts that warm weather is involved.

"I can find very little reason for a big movement in oil prices," said Charles Perry, chairman of energy-consulting firm Perry Management.

"Weather is really not that big of an influence on oil prices, when most crude is converted to gasoline -- plus the natural-gas prices have not moved," he said. Since the start of the year, natural-gas futures have moved less than 1%.


Most crude oil is converted to gasoline.

The $6 billion of gasoline futures that are no longer needed for commodity funds based on the Goldman Sachs Index are surely involved somehow.

No one seems to believe that OPEC is going to cut production, no one but Royal Dutch Shell seems to care what's going on in Nigeria, and news of a million barrel a day interruption in Russian oil supplies doesn't seem to matter either.

Hugo Chavez? Mahmoud Ahmadinejad? Irrelevant.

Like stock markets, fear seems to have been completely removed from the oil market.

Worse for Investors

What's worse is that if you're invested in oil through a fund that tracks futures prices, purchasing near month oil futures contracts and then rolling them over every month, you're losing money with each new month due to what is now an extreme form of "contango".

This story($) from the Wall Street Journal explains.

Oil-futures contracts expire every month. Investors holding the most current contracts have to buy new ones to replace them if they want to maintain their positions. In the past couple of years -- in part, because of the influx of financial investors making long-range bets -- these contracts have gotten pricier the further into the future they are scheduled to be delivered, something known as contango. That raises the cost of keeping a position in the market. It's almost like the difference between walking a mile, and walking a mile uphill.

About two years ago, spot prices of crude were higher than future months, something known as backwardation, which boosted investors' returns every month.

In practical terms, for most investors with oil in their portfolio, the cost of rolling over the expiring near-month futures contract into the one for the next month's delivery is now more than $1.25 a barrel. The price of oil could be unchanged at $50 per barrel, and an investor would still lose 2.5% because of these costs.
This is affecting large institutional investors, such as pension funds, which have been pouring into commodities in recent years, seeking to diversify their portfolios. A few years ago, they were happy to pay the "roll cost" to hold oil, because its price was rising and canceled out carrying costs in the futures markets.
Nobody is predicting an end to investors' interest in commodities as a way to diversify their portfolios. The California Public Employees' Retirement System, or Calpers, approved a pilot program this past fall to invest directly in commodities-futures markets, and it is one of a growing number of pension funds planning to devote a much larger allocation to the sector.

But these investors also may seek to adjust their allocations to indexes that are less energy-focused than, say, the Goldman index. Because roughly $60 billion is invested in funds linked to the Goldman index, pulling out or switching allocations rapidly could cause further downward pressure on the oil markets, some traders and economists say.

This condition was particularly noticeable a couple months ago when a futures contract plunged about two dollars just before it expired while prices for all other delivery dates held steady. Anyone selling an expiring contract would have had an immediate loss of two dollars when moving to the next month's contract.

Different funds investing in oil futures have novel approaches to counter this condition - selling the near month contract at opportune times each month or using a mix of contracts with later delivery months are two approaches - but investing in oil futures seems to be fraught with difficulty if the intent is simply to track the price of crude oil.

For anyone owning the United States Oil Fund (AMEX:USO) since its inception last spring, your buy-and-hold experience looks a lot like the chart below - the gap between the near month futures contract and the share price of the fund has widened from $3 last March to as much as $9 in recent weeks.

There has got to be a better way for the ordinary investor to obtain exposure to the most important of all commodities.

Hedge funds are now reportedly buying and storing the stuff themselves - similar to the gold and silver ETFs that buy and store the physical commodity, then offer shares to others. Paying a couple percent a year in storage costs would seem to be an attractive alternative to the chart above.

Losing $6 a barrel on top of a 20 percent decline since the highs last summer doesn't seem like a very good long-term approach.

Naturally, if oil heads back toward $100 a barrel, few will care how well an oil fund tracks the price of oil.