Watch this signal to see if oil’s recovery is for real By William Watts Published: Feb 6, 2015 8:49 a.m. ET

http://www.marketwatch.com/story/watch-this-signal-to-see-if-oils-recovery-is-for-real-2015-02-06?link=sfmw_fb

Watch this signal to see if oil’s recovery is for real – MarketWatch// <![CDATA[
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NEW YORK (MarketWatch)—Can oil futures sustain an admittedly volatile rebound that has left crude prices up around 14% from six-year lows in six sessions? It might all depend on how traders react to storage incentives.

In other words, it won’t be nearby futures contracts that tell the story. The clue will come from how oil futures for delivery months or years into the future perform, strategists say.

First, though, it’s important to note that the oil market is in a condition known as “contango” (see chart below). This means that the spot price for oil is lower than the price for future delivery (when the nearby price is higher than the future price, that is known as “backwardation.”) As the chart shows, the contango has been deepening, as is often the case in bearish episodes.

For example, Nymex West Texas Intermediate crude for March delivery CLH5, +1.88%  settled Thursday at $50.48 a barrel, while oil for delivery a year later in March 2016 CLH6, +0.86%  finished at $60.96.

In the Brent market, March 2015 futures LCOH5, +1.04%  settled at $56.57 a barrel versus $66.12 for the March 2016 LCOH6, +1.18%  contract, a smaller but still significant premium for the year-ahead contract.

This sort of disparity can provide a trading opportunity. Here’s how it works:

If the premium is wide enough to cover storage costs, it provides an incentive for physical traders to store crude. That’s contributed to the recent run-up in crude supplies, with U.S. inventories now the largest in eight decades.

In fact, the differential between nearby and longer-dated futures is wide enough that deep-pocketed commodity-trading firms have started to buy more expensive floating storage, i.e. oil tankers, in an effort to take advantage of the contango. One large trading firm even booked a three-million-barrel-capacity tanker, one of the world’s largest, to store oil, Reuters reported last month.

Here’s an example of how it works from Vikas Dwivedi, global oil and gas strategist at Macquarie in Houston:

  • Buy the physical crude, say, for example, dated Brent for $55.10 per barrel
  • Obtain a VLCC (very large crude carrier). Capacity: two million barrels Cost: $1.15 per barrel per month.
  • Add monthly financing cost: $55.10 x 10% = $5.51 per year or $0.45 per barrel per month
  • Full monthly cost per barrel to store oil is $1.15 + $0.45 = $1.60 per barrel.
  • Sell second month Brent futures at $57.78 to deliver the oil against from the VLCC
  • Total economics = $57.78 sale price – $55.10 purchase price – $1.60 cost of carry = $1.08 per barrel of risk free profit

Analysts say that large storage increases by themselves aren’t necessarily bearish. Indeed, the notion that traders are buying crude oil and locking it away in storage is getting some credit for the rebound in oil futures.

But the market might be facing a moment of truth.

“If the back end of the curve fails to benefit from the recent price increase, we would see a high chance for the front end to reverse the latest gains,” wrote strategists at JBC Energy in Vienna on Wednesday.

In other words, if the contango doesn’t steepen, the incentive to store will fade away, making more crude readily available and weighing down the market. The need for a steeper contango will be amplified as storage tightens, driving costs higher.

Macquarie’s Dwivedi is skeptical that oil has bottomed.

“There is a chance the oil markets were already discounting the large oversupplies we are expecting when the recent lows were reached but we doubt i t— commodity markets are rarely that efficient and if they were, the back of the Brent curve would already be trading in the low $80s instead of the mid-$60 range,” he wrote.

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