Crude Oil Buy Is an Extremely Dangerous Play

in #investing6 months ago

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Oil Platform Rig in Russia (Pixabay.com)

  • The price of crude oil is extremely attractive now, but buy is still too dangerous.
  • Time works against us in the form of contango.
  • We either have to wait or we can buy oil stocks instead of crude.
  • Familiarize yourself with the concepts of contango and backwardation, they happen regularly by all commodities.

Very Attractive Crude Price Level

Many small investors are now interested in crude oil buying speculation as prices literally collapsed in March. After the unsuccessful OPEC-meeting, the press wrote about a Saudi-Arabian-Russian price war. WTI Crude crashed from around $60 at the beginning of the year 2020 to $20 and some below. That is a 19-year record level, approximately. The heavily discounted crude price is attractive because the price of oil has made big bounces in the past. (For example, in 2016-2017, or 2009.)

Last week, U.S. President Donald Trump put pressure on the parties to agree to cut oil production. At the time of writing, it is not known whether this will be achieved. And if so, whether it will be effective. Oil consumption in April could be 23 percent lower than a year earlier (by the prognosis of Rystad Energy). Meanwhile, production by major producers has even increased a lot recently.

Two Main Dangers for Crude Buys

The entire world is facing severe economic depression because of coronavirus. We can’t say on which level the price of crude oil will be tomorrow or next month. Perhaps very high, maybe very low. But it is very important to draw attention now to some dangers that threaten investors who speculate on oil. And the phenomena to discuss in this article are common to most other commodities, too. Also, for example, the futures contracts of the VIX, an index that measures the volatility of the S&P 500 stock index.

Cheap oil offers a great opportunity, but also means a lot of danger. The very first one may be the global depression. If the coronavirus pandemics cause a deep and very long recession and oil producers don’t cut their output, the prices can fall much further. And for a long time. Oil storage capacities are almost full already.

What Means Contango for Oil Buys?

But the phenomenon of contango signifies a similar huge danger for oil buyers now. Contango means that the closer settlement prices are lower than the more distant ones. So, if we buy crude futures and the price does not rise quickly, we can only re-enter the position at a higher price later. That causes a continuous loss for crude oil buying investors. Nearby futures positions need to be renewed every month as they expire (run out).

If you buy the nearest month’s futures (for example, WTI Crude Oil, May), it expires in less than a month. You have to buy another product, for example, the next one, June, to hold your long (buying) position. With contango, this next month’s product will have a higher price. Over time, with contango, the prices are, in general, slowly decreasing, nearing their expiration.

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Chart 1: A theoretical commodity futures price in the state of high contango. Monthly price difference by 10 percent.

See the chart of a theoretical investment in strong contango, where the futures price is initially $20, and that is declining slowly to 18. What happens here is, the long position holder has to buy the commodity every month for $20. Every month, the price plummets to $18, and the investor loses 10%. Buys for $20 again, expires at $18, etc. A terrible investment, buying high and selling low every month. Whilst the spot price of the product doesn’t change at all.

How Can You Avoid Contango Losses?

How can you avoid losses caused by contango as a crude oil buyer? Easy: Don’t buy it. It is too dangerous. It is only for professional and short term players, for now. Don’t buy and hold crude futures - or any futures - in times of high contango. (And don’t short futures in case of high backwardation, see later.) You can buy crude oil if contango is low or doesn’t exist.

If you want to take advantage of cheap oil, it can be better to buy shares of oil companies. These, too, have plummeted in recent weeks along with oil prices. If the oil recovers, their price will also rise, at least it is probable. Here, even significant dividends are expected of them. If you have to wait a long time for these stocks to recover, because the crisis stays here for a long time, at least you don’t have to pay the losses of contango. There are also a lot of ETF-s (Exchange-Traded Funds) on the US and European stock markets containing oil companies (like FILL, XOP, XLE, etc.)

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Chart 2: Contango and backwardation in WTI crude oil prices (futures 2nd month/futures 1st month). Over the red line: contango, below: backwardation. (Tradingview.com)

There Are Much More Points to Consider. This Post Continues On: Agelessfinance.com

More Important Readings for You About Your Money

Disclaimer 1

I’m not a certified financial advisor nor a certified financial analyst, accountant nor lawyer. The contents on my site and in my posts are for informational and entertainment purposes and reflecting my collection of data, ideas, opinions. Please, make your proper research or consult your advisors before making any investment or financial or legal decisions.

Disclaimer 2

I have open positions in global energy companies stocks (long) and crude oil (short) at the time of writing.

(Photos: Pixabay.com.)

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Very interesting 🧐 blog post and I totally agree with you. For the past 3 years, I have Been a structural short of the following sectors:

  • Banks
  • Telco
  • Oil
  • Automobile

Best,

@vlemon