Another Reason Oil is Headed Higher

People have been scratching their heads wondering why the price of oil has held up relatively well this year in the face of a global slowdown and decreased energy demand in the United States.

Fundamentalists will point to continued strong demand for oil from emerging markets like China and decreasing oil output from non-OPEC producing nations such as Russia and Mexico. But then we have the conspiracy theorists who say the only reason that oil prices are so high is due solely to huge quantities of oil being held offshore in tankers by those greedy oil companies in order to boost their profits.

First of all, why would anyone want to store oil in tankers and not sell it? After all, it costs money to charter those oil supertankers. Storing oil in tankers does make sense if the price difference between crude oil sold for immediate delivery and the price on oil futures for one-year forward is large.

There is a condition called contango (no, it’s not a tropical disease) where the future prices for a commodity are higher than the current spot prices for the commodity. If the difference is large enough, it does make economic sense to hold off selling that commodity at current prices and store it, if possible, and instead sell it at some future date for a higher, more profitable price.

We have recently had a large contango in the oil market. In January, we saw an all-time high contango in oil – an incredible $23.70 a barrel.

That was quite an incentive to just keep any oil you had and sell it at a later date, even after paying to have the oil stored in massive oil tankers. And in April, there was a record amount of oil in floating storage – 100-120 million barrels!

Paul Tossetti, Dallas-based director of oil markets at consultant PFC Energy, estimated that it costs 50-60 cents each month – $6-$7.20 per year – to store each barrel on a supertanker. So as long as the contango stayed above $7 per barrel, it made economic sense to just let the oil sit.

But the market has changed recently…..In the past few months, the contango in the oil market fell to only between $4 and $6 per barrel as US demand began to pick up. The incentive to store oil in supertankers was gone…..By the end of August, there was only 50-60 million barrels of oil being kept off the market. Most industry analysts expect that number to drop to “normal” in 2010.

So it looks like the conditions that led to having all of that oil in floating storage is gone and that most of the oil that was at sea has now hit the market. For an investment standpoint, this should remove the cap that has been on oil prices for most of the year. The conspiracy theorists had it exactly wrong – all of that oil floating at sea was actually holding back the price of oil as traders feared that large amount of oil would hit the market all at once.

Many investors would like to profit from any future rise in the price of oil, but don’t want to buy individual oil stocks for fear that some company-specific factors may cause unpleasant surprises. That’s where the commodity-based exchange-traded funds and exchange-traded notes come into play. They are set-up to match the performance of the underlying commodity, which in this case is oil.

The list of the most heavily-traded long oil ETFs and ETNs include: iPath S&P GSCI Crude Oil Total Return ETN (NYSE: OIL), PowerShares DB Oil Fund ETF (NYSE: DBO), ProShares Ultra DJ-UBS Crude Oil ETF (NYSE: UCO), United States Oil Fund LP ETF (NYSE: USO).

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