Tags: Commodities, Contango Effect, Crude Oil, Energy, Exxon, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Oil, Oil Prices, Royal Dutch Shell, Valero Energy

Wall Street Scrambles its "Contango Convoy" to Capitalize on Higher Oil Demand

By , Contributing Writer, Money Morning •

A 26-mile-long line of idled oil tankers, enough to blockade the English Channel, are firing up their engines and jockeying for position in a race to cash in on the bone-chilling deep-freeze plaguing the North America, Europe, and Asia.

The supertankers, each of which can hold over 2 million barrels of oil, are steaming "all ahead full" to deliver their stores of crude, heating oil and other distillates to the United States.

Their clients - which include several huge Wall Street investment firms - are eager to unwind what's become known as the oil storage trade.

Since late 2008, Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM) and Morgan Stanley (NYSE: MS) and other investors have been accumulating oil and putting it in storage on huge tanker ships.

The tankers were then docked at locations around the world, mostly in the Gulf of Mexico and in Europe, according to a Bloomberg News report, and waited for demand, and oil prices, to go up.

Morgan Stanley, for example, has spent hundreds of millions of dollars to buy and lease offshore storage tanks in New Jersey near New York Harbor, along with oil and gas fields elsewhere.

The banks are maneuvering to take advantage of what oil traders call the "contango effect," which occurs when long-term prices are significantly higher than the current deliverable value.

Contango has been present in the heating oil market since late 2008, providing an incentive for companies to hold rather than sell their oil.

The storage trade is profitable as long as the spread between energy contracts exceeds ship rental, insurance and financing costs.

So what are big investment banks doing dabbling in the oil business?

"For some time now oil has been both a commodity and a financial asset," Dr. Kent Moors, the executive managing partner of Risk Management Associates International LLP and a regular contributor to Money Morning, said in an interview. "Banks can make profits on the spread between wet barrels and futures, futures and options, and new trading platforms will create more new ways to make money in oil."

In other words, the oil gambit is another potential profit center for investment banks struggling to recover from the biggest credit crisis in 70 years.

The laws of supply and demand are pretty clear - buy low when demand is low and sell high when demand is high. But, as usual, it's not quite that simple.

Record Cold Spurs Energy Prices

A relentless surge of cold weather that slammed nearly every country in the Northern Hemisphere, is disrupting travel, threatening crops and driving energy and commodity prices higher.

In the United States, snow flurries stretched as far south as Naples, Florida as below-zero temperatures spread over two-thirds of the country spurring demand for heating oil and natural gas.

Frigid temperatures in the United States are expected to boost the country's heating demand to 21% above normal, with demand in the Northeast - which consumes about four-fifths of U.S heating oil - 11% above average levels, Bloomberg reported.

The increase in demand has the energy complex on the rise across the board. Oil prices rose to a 14-month high of $83.52 in New York trading last week, and heating oil prices are hovering around $2.20 a gallon, their highest levels since mid-October.

And that's where contango comes into play: As the current price for heating oil rises, it becomes less profitable to store and more profitable to sell.

Now that the U.S. cold snap has spiked demand for heating oil and other distillates, raising prices along with it, the tankers are headed back to the Northeast, the trade Web site HeatingOil.com reports, carrying with them potential profits.

But it's not as simple as it looks, Dr. Moors said.

Oil traders are required to settle their accounts daily, answering margin calls on long and short positions if the market moves against them. Their survival is based largely on overnight credit from banks, where they take short-term loans until the market moves in their favor.

But when the recent credit crunch hit, the banks closed the capital spigot and a lot of traders went under, Moors explained. And just like a foreclosure on a house, the banks end up owning the rights to the contracts of oil.

In fact, many of the banks roll over the oil contracts on a monthly basis for liquidity reasons, meaning not all of the oil the banks have in storage was purchased as far back as 2008, when oil traded in the low $30's. In fact, some of it was obtained at much higher prices.

Profits Shrink With Spreads

There's another complication for oil owners that makes the floating storage trade risky.

The spread between the spot price of oil and future delivery has been shrinking as prices increase. A year ago, the spread between the first and sixth Brent crude-oil contracts traded on the London-based Intercontinental Exchange Futures Europe exchange was 23%. Now, it's 4%. The spread all the way out to January 2011 is only $7 and there is certainly no guarantee oil prices will be that high for sellers then.

The contango spread for heating oil shrank to a low of $2 this week from about $18 a ton in December as greater demand for heating oil has increased current prices.

Another factor is lease and crew costs. The cost of leasing a tanker runs $40,212 a day now, according to the median estimate in a Bloomberg survey of 15 analysts, traders and shipbrokers.

As frigid temperatures persist in the United States and Europe, more cargoes may move out of storage making it cheaper to store oil afloat, but with contango spreads tightening, it spells reduced demand for 26 miles of oil tankers.

Also, the profit dynamic in the oil business has changed, Moors said, to favor so-called downstream oil refiners over upstream (or integrated) oil companies like Exxon Mobile (NYSE: XOM) or Royal Dutch Shell (ADR NYSE: RDS.A, RDS.B), Moors explained.

In reaction to overseas competition and lower prices in 2008, U.S. refineries cut production by 8-14%. Now operating with limited capacity as demand increases, refineries can raise prices more than upstream producers.

As demand increases, the refineries will draw down existing stockpiles, while refining the new oil into heating oil, gasoline and other distillates at higher profit margins

It was one thing to store oil when crude was below $40 and future months were much higher. Risk factors are much higher now, and it looks like the oil storage trade will soon be unwound.

For investors looking to profit from the cold snap, as well as longer term, Moors favors Valero Energy Corp. (NYSE: VLO) as a likely candidate to benefit from spiraling demand. Moors points out that Valero has recently increased the efficiency of its distribution channels by opening new gas stations around the country to sell its gasoline, compressing the delivery network and increasing profit margins.

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