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Oil in Contango. See Those Ships?

Floating storage is back in vogue for crude oil tankers...
 
YOU MAY have come across the word "contango" in an oil-related news report or article recently and wondered, "What's contango?" writes Marin Katusa, chief energy investment strategist at Doug Casey's Casey Research.
 
It isn't the Chinese version of the tango.
 
Contango is a condition in a commodity market where the futures price for the commodity is higher than the current spot price. [Ed. Usually, consumed commodities like oil, wheat or copper are in 'backwardation', with today more costly than the future.] And essentially, the future price of oil is now higher than what oil is worth today.
 
 
The above forward curve on oil is what contango looks like. There's more value placed on a barrel of oil tomorrow than over a barrel today – and again further into the future – because of the increased cost of storage in the meantime.
 
Crude oil under $50 per barrel may seem to put most of the producers out of business. But many oil and gas exploring and producing (E&P) companies are sheltered from falling prices in the form of hedges.
 
Often, companies will lock in a price for their future production in the form of a futures commodity contract. This provides the company with price stability, as it's sure to realize the price it locked in at some future date when it must deliver its oil.
 
But the market will always figure out a way to make money – and here's one opportunity: the current oil contango leads to plenty of demand for storage of that extra oil production.
 
 
With US shale being one of the main culprits of excess crude oil production, stockpiles of crude in US markets have risen above seasonally adjusted highs in the last year.
 
This abundance of stored crude has pushed the current spot price of crude oil toward five-year lows, as current demand is just not there to take on more crude production.
 
When in contango, a guaranteed result is an increase in demand for cheap storage of the commodity, in order to clip the profit between the higher commodity price in the future versus what's being paid for the commodity at present. This is precisely what's playing out in oil today.
 
Looking back at the similarities of the 2009 dramatic free-fall in oil prices to $35 per barrel, after a five-year hiatus, crude has returned to a similar price point, and the futures market has returned to contango (green shows oil in contango).
 
 
Oil traders are now taking advantage of the contango curve through floating storage in the form of waterborne oil tankers.
 
This is what a big oil tanker looks like:
 
 
Here's a photo taken out my living room window in Vancouver – and this is non-busy part of the harbor. At times when I do my runs along the seawall, there have been up to 30 large oil tankers just sitting in the harbor.
 
 
All that pricey Vancouver waterfront will have an incredible view of even more oil tankers in the years to come when the pipelines are eventually built. I can only imagine what the major import harbors of China and the US look like...never mind the number of oil tankers sitting in the export nations' harbors and the Strait of Hormuz. Multiply the above red circles by 50.
 
As the spread between future delivery of oil and the spot price widened in 2014, traders looking to profit from the spread would purchase crude at spot prices and store it on oil tanker ships out at sea. The difference between the spread and the cost to store the crude per barrel is referred to as the "arbitrage profit" taken by traders.
 
Scale is a very important factor in crude storage at sea: therefore, traders used very large crude carriers (VLCC) and Suezmax ships that hold between 1-2 million barrels of crude oil.
In the late summer of 2014, rates charged for crude tankers began to climb to yearly highs because of the lower price that spurred hoarding of crude oil. This encouraged VLCCs to lock in one-year time charter rates close to and above their breakeven costs to operate the ship.
 
Time charter rates share similarities to the oil futures market, as ships are able to lock in a daily rate for the use of their ships over a fairly long period of time. VLCC spot rates have reached around $51,000 per day; however, these rates tend to be booked for a shorter period of around three months. These higher spot rates tend to reflect the higher cost paid to crew a VLCC currently against locking in crew and operating costs over a longer-term charter that could last a year. Crude oil is often stored on floating VLCCs for periods of six months to a year depending, on the contango spread.
 
Many VLCCs are locking in year-long time charter rates at or above $30,000-$33,000 per day, as that tends to be the break-even rate to operate the vessel.
 
If we assume that a VLCC charges their breakeven charter rate and we include insurance, fuel, and financing costs that would be paid by the charterer, storage on most VLCCs in the 1-2 million barrel ranges are barely economic at best.
 
However, they'll soon become profitable across the board once the oil futures and spot price spread widens above $6-$7 per barrel. The red star depicts the current spread between the six-month futures contract from the futures price in February 2015.
 
 
Currently companies are losing just under $0.20 per barrel storing crude for delivery in six months. However, once that $6-$7 hurdle spread is achieved, most VLCCs carrying 2 million barrels of crude will be economic to take advantage of the arbitrage in the contango futures curve.
 
VLCCs store 1.25-2 million barrels of oil for each cargo. Globally, there are 634 VLCCs with around 1.2 billion barrels of storage capacity, or over one-third of the US's total oil production.
 
The VLCC market is fairly fractured, and the largest fleet of VLCCs by a publicly traded company belongs to Frontline Ltd. with 25 VLCCs. The largest private-company VLCC fleet belongs to Tankers International with 37 VLCCs. In early December, Frontline and Tankers International created a joint venture to control around 10% of the VLCC market. Other smaller VLCC fleets belong to DHT with 16 VLCCS, and Navios Maritime with 8 VLCCs.
 
The lowest time charter breakeven costs of $24,000 per day are associated with the largest VLCC fleets from Frontline Ltd and Tankers International. This is followed by the smaller fleets that have time charter break-even costs of around $29,000 per day. Of course, on average the breakeven costs associated with most VLCCs is around $30,000 per day, and current time charter rates are around $33,000.
 
Investing in companies with VLCC fleets as the contango trade develops can generate great potential for further profits for investors. The focus of these investments would be between the publicly traded companies.
 
But one must consider that investing in these companies can be very volatile because of the forward curve's ability to quickly change. It isn't for the faint of heart.
 
However, if current oil prices stay low, there will be an increase in tanker storage demand and thus a sustained increase in the spot price of VLCCs. However, eventually low prices cure low prices, and the market goes from contango to backwardation. It always does and always will.
 
Shipping companies have been burdened by unprofitable spot and charter pricing since the financial crisis, and these rates have only recently started to increase. So warning! I want to remind all investors betting on this play that they're actually speculating, not investing. There's a lot of risk for one to think playing the tankers is a sure bet. I have a pretty large network of professional traders and resource investors, and I do not want to see the retail crowd get caught on the wrong side of the contango situation.
 
In the past, spot rates for the VLCCs usually decline into February and have dropped to as low as under $20,000 per day. It is entirely possible that if the day rates of VLCCs go back to 2012-2013 levels, operators will lose money.
 
Conclusion: this speculation on tankers is entirely dependent on the spot price and the forward curve. What should be stressed are the similarities to the short-lived gas rally in the winter of 2013-'14, and the effect these prices have had on North American natural gas companies. A specific event similar to the polar vortex has occurred in the oil market, which has spurred a seasonal increase in the spot price tankers charge to move and store oil.
 
However, much like the North American natural gas market, the VLCC market is oversupplied; a temporary increase in spot prices that have led to increased transport and storage of oil will not be enough to lift these carriers from choppy waters ahead. Future VLCC supplies are expected to rise, with 20 net VLCCs being built and delivered in 2015 and 33 in 2016. This is much more than the 17 net VLCCs added in 2013 and 9 in 2014.
 
Another looming and very possible threat to these companies is the same debt threat that affected energy debt markets as global oil prices plummeted. If VLCC and other crude carriers experience a fall in spot prices, these companies' junk debt could be downgraded to some of the lowest debt grades that border a default rating. This will increase financing costs and in turn increase the operating breakeven costs to operate these crude carrying vessels.
 
The supply factor, high debt, and potentially short-lived seasonally high spot market could all affect the long-term appreciation of these VLCC stock prices. Investing in these companies is very risky over the long run, but a possible trade exists if storage and transport of oil continues to increase for these crude carriers.
 
Meanwhile, if you talk to resource industry titans – the ones who've made hundreds of millions of Dollars and been in the sector for 40 years – they're now saying that they've never seen the resource share prices this bad.
 
Brokerage firms focused on the resource sector have not just laid off most of their staffs, but many have shut their doors.
 
The young talent is the first group to be laid off, and there's a serious crisis developing in the sector, as many of the smart young guns have left the sector to claim their fortunes in other sectors.
 
There's blood in the streets in the resource sector. And if you believe that, as I do, to be successful in the resource sector one must be a contrarian to be rich, now is the time to act. I have invested more money in the junior resource sector in the last six months than I have in the last five years. I believe we're in contango for resource stocks, meaning that the future price of the best juniors will be worth much more than they are currently.
 
I can't make the trade for you, but I can help you help yourself. I'm making big bets – are you ready to step up and join me?

Doug Casey is a world-renowned investor and author, whose book Crisis Investing was #1 on the New York Times bestseller list for 29 consecutive weeks, a record at the time.

He has been a featured guest on hundreds of radio and TV shows, including David Letterman, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin, NBC News, and CNN; and has been the topic of numerous features in periodicals such as Time, Forbes, People and the Washington Post.

His firm, Casey Research, LLC., publishes a variety of newsletters and web sites with a combined weekly audience in excess of 200,000, largely high net worth investors with an interest in resource development and international real estate.

See full archive of Doug Casey articles

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