While slumps in the global prices of oil might alarm oil companies and oil exporting countries, the situation brings forth opportunity for several traders and investors. They respond to these price slumps by purchasing and storing millions of oil barrels in large shipping vessels. This response is referred to as a contango strategy.
By definition, a contango is a situation that involves an assumption that the future price of a particular commodity will be higher than the current and spot price. Thus, during this situation, traders and investors would often buy this commodity in bulk to resell at a higher price in the future. Furthermore, during this situation, traders and investors believe that people are willing to pay more for a commodity at some point in the future than to carry the burden associated with costs of storage and current commodity price.
A contango is common for non-perishable commodity that has costs of carry, including expenses associated with warehousing or storage, maintenance, and transportation.
In the case of oil, oil traders assume that they can eventually sell their purchased and stored oil at a higher price in the future. Others are also entering contracts with regional market distributors. To be specific, after purchasing millions of oil barrels and storing them afloat a vessel near a regional market, they would enter in an agreement with buyers who are willing to pay for the commodity at an expected higher price and have it delivered somewhere in the future. Again, this illustrates the fact that people and for this instance, buyers are willing to pay more for a commodity at some point in the future than to carry the burden associated with costs of storage and current commodity price.
Oil traders are nonetheless exploiting the situation. In this strategy, they also weight the associated costs and benefits as part of risk management.
Of course, these oil traders have to shoulder initial costs associated with renting large shipping vessels where they will store the purchased oil barrels to keep them afloat the sea, especially near designated regional markets. These costs also include maintenance or upkeep expenses. However, they believe these costs would be insubstantial from a potential gains arising from future oil price recovery. Furthermore, keeping millions of oil barrel afloat the sea and near regional markets would save them transportation costs in the future.
Implementing a contango strategy during global slumps in oil prices makes sense. It is important to take note of the fact that oil traders have been using this strategy during several instances of oil contagion. For example, in 2008, prices of oil collapsed from $145 a barrel to $40 a barrel. By 2009, while oil remained cheap, several oil traders decided to buy millions of oil barrels and store them in shipping vessels. Thus, when oil price increased in the following years, these traders have considerably benefitted.
The drawback emerging from exploiting contango primarily involves future uncertainty. The entire situation can be costly for traders and investors especially if the price continues to falter or low price remains for an extended period. In other words, the lengthier the low price point period, the costlier it is for traders and investors to hold on to their purchased commodity.
Nonetheless, it is safe to say that like any other investments or ventures, the strategy of buying oil and storing them in floating vessels has its fair share of risks. Remember that storing oil in shipping vessels has corresponding costs. If oil price continues to slump or if it never recovered, the running costs incurred by oil traders might be far greater than the future value of their oil.
A positive offshoot arising from this contango strategy during oil price slumps centers on supporting the shipping industry as it creates a high demand for large oil tankers. Businesses that have large oil shipping vessels are definitely earning from these oil traders and investors.