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Weak Oil Prices and Contango Structure is a Double Whammy for this ETF

Weak Oil Prices and Contango Structure is a Double Whammy for this ETF

Oil prices continue to fall as demand destruction muddies the outlook for oil prices. As you monitor oil futures, it tells more of an aggregate story as the regional stories can become even more of an issue. Consider that in parts of Canada, the price of oil is going for about $4.18 a barrel. That’s less than the price of a pint of beer in some establishments. Some oil analysts are now projecting oil prices to drop below $10 a barrel. That seems really drastic, but such is the uncertain time we live in.

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  • As the glut of oil supply causes storage facilities or become filled, the term structure of the oil futures market is continuing to steepen. This is reflected by sharply rising prices as you look at future expirations for oil futures. This dynamic isn’t reflecting higher oil prices in the future, but rather the significant costs to finance and store oil. The potentially positive dynamic for oil prices in the near term is the indication that oil traders are looking for oil tankers to store oil. When the term structure is extremely steep, there is a potential to buy a near term oil futures contract and simultaneously sell a far term contract and lock in a guaranteed spread less storage costs. This obligates the traders to take delivery of the oil at expiration, store it on a ship and then deliver it as part of the contract they sold.

    This potential near-term demand story will take a little time to play out and won’t immediately erase the contango structure. This is a huge structural disadvantage for a product like the United States Oil Fund (USO). Since the product tracks the near-term oil futures contract, as the roll happens daily from one contract to the next, it takes a loss. This loss is reflected in the tracking issues of this product with active oil futures contract price.

    This presents opportunity to play the bearish term structure by shorting USO or rather utilizing option contracts to minimize risk. A 15 May 5/4 long put vertical can be purchased for around $0.55. This provides a profit of $45 a contract or 82% ROR if the price of USO closes below $4 at expiration. Consider closing early if it can be sold $0.80 or higher.

     

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