Oil Contango Narrows

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"Hey what's this? Oil prices were up nearly 9% in New York, or about US$3.73 a barrel to $45 a barrel."

Hey what's this? Oil prices were up nearly 9% in New York, or about US$3.73 a barrel to $45 a barrel. OPEC production cuts and inventory reductions have brought global supply more into line with global demand (which is dramatically reduced owning to the world financial calamity).

You might not have noticed, but oil has been in "contango" for awhile now. That's a trader's term that describes a situation where the futures price of a commodity is higher than the spot price. There are several reasons why this might be the case for oil.

One obvious reason is that traders see the oil market moving back into equilibrium (reduced supply, stabilized demand). Lately, there is some hope that China's stimulus package reignites industrial production or at least commodity demand.

There's also a more macroeconomic reason to expect higher oil prices. Global monetary policy is pretty accommodating at the moment. There is a great debate over whether or not this will lead to higher inflation in real tangible goods. If you're on one particular side of the debate, you'd expect a big increase in the money supply to lead to higher general prices, especially for commodities like oil. Thus the higher futures price.

Of all the explanations for the contango, the one that makes the most sense to us is actually the most indirect. The oil price crash of 2008 has virtually guaranteed future supply constraints. As major integrated oil companies cut back exploration budgets, and as unconventional energy alternatives got put out of business by the crashing price of crude, the foundation was laid for a massive spike in oil prices sometime later this year.

That spike won't come from some unexpected recovery in demand or global growth. It will come from chronic production declines from the world's oil industry and national oil companies. More on that next week. In the meantime, the contango is narrowing in the sense that spot prices are catching up with futures prices. There are still some trades to be made, though.

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