Oil: Squandered opportunities

Traders are seasick from the oil markets lately; the volatility has been so extreme. Aside from the obvious macro-factors, what else is driving the abnormally large swings in crude oil?

It's called "contango." Contango occurs when futures prices are higher than current prices. The scenarios are not uncommon, but the recent spread widths are extreme by any measure.

For example: the April 2009 crude oil contract is around $38.10 -- while the April 2010 crude contract, crude for delivery a year from now, is trading at $50.26. That's a $12.16 spread.
That means major oil companies like Royal Dutch Shell can store oil on tankers and then sell the April 2010 contract at $50.26.

Even factoring in the cost of storage, they come out better selling forward than selling at current market prices. This maneuvering causes additional volatility throughout the oil curve, as physical oil companies position themselves in the futures markets to take advantage.

Contract rolls
Another strategy we see consistently in the energy market is contract rolls at major hedge funds, commodity-trading advisers and exchange-traded funds. One ETF is the U.S. Oil Fund LP (USO:USO 25.39, +0.91, +3.7%) , the world's largest oil fund, said to account for 22% of the outstanding front-month contracts each month.

When the front-month contract approaches expiration, this gigantic ETF must sell its position in the expiring month and buy it back for the coming month.

Also, long-term trends following CTAs and hedge funds have been short on the front months. When a contract expiration approaches, the fund has to roll its short position into the next month's contract, since most CTAs and hedge funds have neither the ability nor the interest to take physical delivery of oil.

The volatility in energy is due to the gigantic tug of war going on around key days of the month where funds, ETFs and oil companies are adjusting for the roll.