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Contango Lessons: Dancing with the Drop in Oil Prices

10/31/2018

With the recent dip in oil prices, a familiar foe has reemerged—the dreaded contango, a situation in which prices for immediate delivery of oil are lower than delivery, in, say, three months’ time. Many market participants describe this as an indicator that a glut of supply of this commodity is seeping back into the market, after what’s been a period of relatively balanced fundamentals, and that the outlook for owning oil has dimmed. But is that true? Does the contango revival have dire consequences for being long oil? Let’s dust off those dancing shoes and reacquaint ourselves with one of oil’s oldest moves.


What is contango?

The term’s origins are, like oil, murky. The word contango dates to the 19th-century London Stock Exchange and is thought to be an alteration of continue. In those days contango referred to the fee a buyer paid to a seller to defer settlement of a trade they’d agreed on. The fee essentially covered the interest the seller missed out on by not being paid immediately.


Nowadays contango, also sometimes called forwardation, describes instances in which nearer-maturing futures contracts command a lower price than contracts maturing at a later date. There are numerous theories why that may occur, but many argue that this should be the natural state of pricing given the costs incurred to physically own and store a nonperishable commodity such as oil.


The return of contango

Recently the market for West Texas Intermediate (WTI) oil reentered a contango state following a roughly yearlong period of experiencing the reverse pricing dynamic (referred to as backwardation). The two charts below show this in greater detail.



WTI Oil Futures Curve Chart

Sources: Bloomberg, CME Group as of 10/24/2018



Oil Price Difference Chart

Sources: Bloomberg, CME Group



What does contango mean for oil prices?

Some commentators are saying that this switch back to contango in the oil market should be a wake-up call—that returns will erode and that long holders should consider selling because prices are going down. This advice, however, seems to run counter to historical evidence of what an investor would have actually experienced by owning oil during bouts of contango. To clear this matter up, the below scatterplot presents the price differential for the four-month and one-month deliveries versus the subsequent three-month total return of oil. 



Price Differential Scatter updated chart

Sources: Bloomberg, CME Group, S&P Dow Jones Indices



If the commentators were right, we’d expect to see a linear pattern starting in the northeast quadrant and moving to the southwest quadrant, showing that oil prices generally decline during periods of contango. However, as you can see, no such pattern exists. In fact, it seems rather random what the outcome will be in the future given a curve that’s in contango today. Sometimes oil has rallied during periods of contango (49% of the time), and sometimes it hasn’t (51% of the time). All we can say based on this past performance is that given the current four-month to one-month difference of –$0.26, we’d expect oil prices to be somewhere between $45 and $100 in three months’ time—a range so wide that it’s practically useless as a forecast.


The bottom line

The oil market moving into contango isn’t the smoking gun many would have you believe it is, but the heightened risk of a concentrated position in oil most certainly is. If you find yourself concerned about your oil exposure, it may be time to diversify your commodity risk by adding a new dancing partner with a few more moves.


Potential Parametric Solution

Our Commodity Strategy seeks to avoid the concentrations that occur in mainstream commodity indexes by investing broadly across commodity types. Our active reweighting and systematic rebalancing seek to capture a diversification premium.



Greg Liebl

Greg Liebl, CFA - Portfolio Manager

Mr. Liebl is responsible for all Parametric proprietary and non-discretionary commodity strategies in the Minneapolis Investment Center. Since joining Parametric in 2010*, Greg has provided Portfolio Management in the areas of risk and exposure management and customized implementation solutions.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.

 


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.

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