The Contango Trade:

A Cost of Capital Competition

By Lewis Hart

Black Friday 2014: As crude oil prices began their precipitous descent from
$100 per barrel (bbl.) to less than $50 per bbl., a specter of protracted gloom
washed over oil producers across the globe.

8 Brown Brothers Harriman  |  C O M M O D I T Y M A R K E T S U P D A T E

Energy exploration and production (E&P) companies, which between today’s price for crude oil delivery compared with the future
had been generating returns of more than 30% at $100 per bbl. price, also known as the time spread or the calendar spread.
of crude oil, suddenly faced a murkier future. The pessimism
afflicting the producer community was perhaps only surpassed Daily Global Production and Consumption
120
by the optimism – or perhaps opportunism – that swept across
oil trading desks in places such as London, Houston, Geneva, and 110

Singapore. Traders welcomed the sudden return of price volatility 100

Millions of bbl.
after nearly eight years of historically low levels. 90

80
WTI and Brent Crude Spot Prices
70
WTI Brent
$120
60
$110

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015
$100
Reflects production and consumption of liquid fuels Production Consumption
$90 (crude oil, lease condensates, natural gas plant liquids,
other liquids, refinery processing gains, and alcohol)
$80
USD/bbl.

Source: DOE, EIA, Bloomberg and BBH Analysis

$70

$60

$50

$40
Term Structure of Crude Oil Prices
$30

$20
Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15
As with interest rates, the “term structure” in commod-
Source: Bloomberg and BBH Analysis ity prices refers to the relationship between prices for a
given commodity for different delivery dates. When the
market is in contango, the spot price of the commodity
WTI Monthly Price Volatility
is less than the future price. Conversely, when the mar-
30%
ket is in backwardation, the spot price of the commodity
20%
is greater than the futures price. The relationship among
10% prices at different points across the curve is generally a
0% function of supply and demand expectations.
(10%)

(20%)

(30%)
The glut of inventory caused the spot price of crude oil to decline
Sep-10

Sep-15
Dec-10

Jun-11

Dec-11

Jun-12

Dec-12

Jun-13

Jun-14

Jun-15
Dec-13

Dec-14

more rapidly than the forward price, resulting in an increase in

the time spread. Traders who had secured long-term oil storage
Source: DOE, EIA, Bloomberg and BBH Analysis
capacity at low rates in advance of the crash through ownership
of storage facilities or long-term leases with third-party operators
Enter Contango were pleased to see the market dislocation. Similarly, storage
If the price crash was unwelcome to the producer community, operators who had not leased all of their storage capacity could
market participants down the supply chain were not complaining, suddenly consider raising the rent.
particularly energy merchants, crude oil storage operators, and
refineries. The arrival of price instability was particularly welcome
by companies whose business models included exposure to one of
the key profit drivers in the energy trading business: the difference

October 2015 9
 U.S. Crude Oil Cushing Stocks merchant could profitably purchase and carry crude, hedge the
70
price risk by selling a futures contract, and still earn a profit, much
60
attention was given to the pure cost of term storage – particularly
floating storage held in offshore tankers – with less emphasis
50 placed on an even more important variable: the structure and
cost of a merchant’s capital.
Millions of bbl.

40

As capital providers and advisors to a number of energy

30
merchants, BBH received many inquiries from clients on financing
contango trades during this period of price volatility. In this article,
20
we zero in on how a company’s cost of capital is a critical and
10
often overlooked variable in determining whether a firm can profit
from periods of contango.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Inventory stocks are measured as weekly ending inventory levels in Cushing, Oklahoma, and exclude strategic petroleum reserves.
Source: DOE, EIA, Bloomberg and BBH Analysis

The Carry Trade: A Crude Primer

After two years of fairly flat and backwardated forward curves – The following variables must be considered when evaluating
when the difference between the spot price and the 12-month whether it makes economic sense for a merchant to
futures contract rarely exceeded $5 per bbl. – the forward curve enter into a contango or cash and carry trade:
suddenly flipped into a condition known as contango, where the
price for delivery in the future exceeded the price for delivery
today by an above-average margin. Similar to the yield curve The Carry Formula
in interest rates, the term structure of the crude oil market –
where the price for future delivery of crude oil is set – can at 1. The crude oil futures price as traded on the exchange
times present opportunities to earn profit with minimal risk for LESS
companies that have the storage capacity – whether leased or
owned – and the capital resources to take advantage of it. 2. The “cash” or “spot” price of a barrel of oil, which
is the price for delivery today

12-Month Time Spread 3. The cost of transporting the oil to its storage location
$15
4. T he cost of storing the oil near an exchange
$10
deliverable location
Contango
market 5. The cost of insuring the oil
12-month minus 1-month WTI spread

$5
6. The cost of financing the oil
$0
= The Carry Profit or Loss
($5)

Backwardated
market

($10)

When the sum of variables 2 through 6, also known as the

($15)
Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 carrying cost, is less than variable 1, a merchant can in theory earn
Source: Bloomberg and BBH Analysis
an arbitrage with virtually no risk by purchasing crude oil inventory
today, placing it into a storage tank or offshore vessel, and selling
As the market shifted into a steeper carry structure, popular media a futures contract. To help mitigate geographic basis risk, the
outlets and research outfits covered the new pricing dynamic in storage must be located near an exchange. As such, given the
depth. But as market observers evaluated whether an energy excess inventory in the marketplace, storing the crude oil for

10 Brown Brothers Harriman  |  C O M M O D I T Y M A R K E T S U P D A T E

future delivery to a refinery looked like a particularly interesting
option for merchants with inventory and access to storage.
What factors drive each of these variables? Variable 1 represents
the price for future delivery at a specific location (Cushing,
Oklahoma, in the case of the West Texas Intermediate futures
contract). Price formation occurs through trading activity on
the futures marketplace and is beyond the merchant’s control.
Similarly, the second variable is set through trading activity in
the spot market. Variables 3 and 4 can vary slightly based on
whether a merchant has secured contractual transportation
capacity (via rail, truck, or barge) and storage capacity in advance
at a predetermined rate. Moreover, the storage cost can differ
among merchants based on whether the merchant owns or
leases storage facilities, when the storage rate was locked in,
if the storage was leased for a period of time, and for how long
the lease rate was locked in. Variable 5, though not a major driver
of the economics, will generally be a function of a merchant’s
scale in the marketplace.
Merchants without the benefit of pre-existing storage capacity
secured before the arrival of contango would be out of luck. As
the forward curve steepened after the crash, storage operators
raised rates to meet increased demand to store excess inventory.
Storage – like all commodities – becomes dearer as demand for
tank space increases relative to the supply of tank space. As
such, unless they had contracted storage in advance at a fixed
rate or owned storage tanks, merchants were by and large shut
out of the carry trade.
Looking at the total carrying costs, financing costs should be lower than storage
costs. However, financing costs are generally a function of balance sheet size
and other credit variables. As such, this element tends to differ most among
merchants and should establish the marginal cost of carry.”
How Much Does Your Capital Cost?
Working Capital Budgeting
If the universe of merchants that had secured fixed price
storage before the arrival of contango was limited, the number
of companies within that universe that could take advantage of
the opportunity was limited even further. The key driver of this
differentiation is rooted in a simple corporate finance concept
known as the weighted average cost of capital (WACC).
We have found that merchants often consider only their debt cost
of capital when evaluating whether it pays to allocate a scarce
resource such as financial capital to a potentially low returning,
albeit low risk, contango trade. Looking at the total carrying costs,
financing costs should be lower than storage costs. However,
financing costs are generally a function of balance sheet size and
other credit variables. As such, this element – variable 6 in the
prior formula – tends to differ most among merchants and should
establish the marginal cost of carry.
Given the low risk profile, contango deals can typically be
funded with high leverage; indeed, the inventory price risk is
hedged, the inventory insured, and the oil often stored in or
near an exchange deliverable location or very liquid market
such as Cushing or Midland, Texas, where it can be turned to
cash quickly. However, these trades are rarely 100% leveraged,
meaning a merchant must allocate some balance sheet equity
to the trade. Furthermore, the leverage typically affects a
merchant’s balance sheet leverage – a ratio capped by most
commodity finance banks – and thus carries an opportunity cost.
October 2015 11
A Tale of Two Contangos
To put it all into perspective, let’s look at a hypothetical but realistic
example. In September 2012, with the cash to 12-month time
spread at approximately negative $1.00 per bbl., midsize energy
There may be temporary arbitrage
merchant Arb-A-Little Energy enters into a five-year take or pay opportunities in a contango
storage contract1 with a well-known operator for 500,000 barrels
of storage capacity in Midland. Arb-A-Little agrees to a monthly market, but so long as the most
lease rate of 40 cents per bbl. This contract gives the merchant
the option, but not the obligation, to store oil in the facility.
creditworthy companies have
access to liquidity, they will likely
Now fast-forward to November 2014: the cash to 12-month
spread widens to almost $10.00 per bbl., peaking at around keep the time spread relatively
$9.90 per bbl. in early March 2015. Arb-A-Little’s head oil trader,
Stephen Smith, enters the office of CFO Gary Guttchek and says: narrow. The conclusion may
“Gary, the cash to 12 has widened substantially! We need to
fill up the tanks in Midland. I think we could make a big profit;
be unsurprising, but few have
we need to act quickly. I can make almost $2.00 per bbl. doing recognized that the contango
nothing – just need to get the crude there as quickly as possible.
That’s almost $1 million in profit for what doesn’t seem like much trade is ultimately a cost of capital
work or risk.”
competition – one that will likely
Gary, skeptical by nature, tells Stephen that he will perform some
always be won by companies with
analysis that afternoon and respond to the trading proposal within
24 hours. As he begins to do the analysis – looking at the variables the cheapest capital.”
described in the earlier formula – certain variables are easy to
quantify: the cash price in Midland, the company’s previously
locked-in storage and insurance costs, and the futures strip for
WTI crude oil. unrelated trading opportunities, which may generate superior
returns for the shareholders.
But calculating the financing costs requires a bit more reflection.
Arb-A-Little’s line of credit from a regional bank bears an effective Gary begins doing the math and concludes the company’s
interest rate of 3%, and the bank requires that the company WACC is actually 8.6%, assuming a capital structure comprising
maintain at least 20% equity relative to total assets at all times. 80% debt and 20% equity, a cost of debt of 3%, and a cost of
While the company could scramble to obtain off-balance financing equity of 35% (representing the company’s average return on
from an alternative source, typically in the form of a short-term equity over the past three years), and assuming a 35% federal
repurchase agreement, the costs and complexity are high, and corporate tax rate. Gary even uses the capital asset pricing model
time is of the essence. To fund the transaction and use the full to back into the cost of equity and calculate a number in the same
storage capacity, Gary would have to draw down approximately range. Suddenly, the economics don’t look so compelling at the
$30 million on his line of credit, tying up a significant chunk of current $10 per bbl. spread. In fact, now equipped with all of the
liquidity and depriving Arb-A-Little of the ability to capitalize on necessary information, Gary calculates that the company would
actually generate a net present value on the trade of negative
$1,959,764 using the 8.6% number as the discount rate.
1
T ake or pay contract: A contract that requires the buyer to pay for a contractually determined
minimum volume, even if delivery is not taken. Its function is to move the volume risk from the
producer to the buyer.

12 Brown Brothers Harriman  |  C O M M O D I T Y M A R K E T S U P D A T E

In order to generate a positive net present value given these
assumptions, the spread would need to expand to around $14.50
per bbl. Even in this simplified analysis, Gary has yet to factor in the
potential location basis risk – that in which the trader could have
to move the oil to Cushing in order to realize the WTI price. The
change in the Midland/Cushing location spread over the carrying
period could further erode or enhance the profit on changes in this
pricing relationship. Now confident in his position, Gary goes back
to Stephen and delivers a clear “no” decision on the trade.
Now let’s take Arb-A-Little’s much larger global competitor, Arb-
A-Lot. Due to its scale, Arb-A-Lot was able to negotiate a slightly
better storage rate of 35 cents per bbl. around the same time in
2012 and at a nearby location with direct access to a pipeline. On
the financing side, the differences become even starker. Arb-A-
Lot’s line of credit from a consortium of international banks carries
an effective interest rate of just 1%. What’s more, the company’s
leverage covenants are far less restrictive, requiring the company
to maintain a minimum equity level of only 5% relative to total
assets. Given the capital structure, Arb-A-Lot focuses more on
high volume/low margin business and has also generated returns
on equity in the 35% range over the past few years.
Arb-A-Lot is in a different position. With these carrying costs
locked in, as shown in the nearby chart, the company can
generate a net profit of $3.40 per bbl. Assuming a 500,000 barrel
trade, Arb-A-Lot’s trade would generate a net present value of
approximately $890,539. And the major difference lies in Arb-
A-Lot’s WACC of 2.4%, compared with Arb-A-Little’s of 8.6%
(calculated using the same corporate tax rate). Arb-A-Lot’s CFO
gives its head trader the green light to execute the trade.
While market participants evaluate the attractiveness of this
arbitrage opportunity, conditions begin to change as prices respond
to the behavior of companies like Arb-A-Lot. By purchasing crude
oil in the spot market, Arb-A-Lot bids up the cash and puts some
downward pressure on the futures price given hedging associated
with the trade. Not surprisingly, the companies with lower costs
like Arb-A-Lot win the cost of capital competition and correct the
temporary market dislocation. The efficient market returns, where
earning a “risk-free” profit is next to impossible.

There may be temporary arbitrage opportuni-

Arb-A-Little Arb-A-Lot ties in a contango market, but so long as the
most creditworthy companies have access to
Cash price per bbl. $60.00 $60.00 liquidity, they will likely keep the time spread
Lease rate, insurance and interest $8.40 $6.60 relatively narrow. The conclusion may be
unsurprising, but few have recognized that the
Carrying cost per bbl.1 $68.40 $66.60 contango trade is ultimately a cost of capital
12-month futures price per bbl. $70.00 $70.00 competition – one that will likely always be
won by companies with the cheapest capital.
Capital Structure Debt/Equity Mix Cost Debt/Equity Mix Cost

Debt 80% 3% 95% 1%

Equity 20% 35% 5% 35%
Corporate tax rate 35% 35%
Net profit per bbl. $1.60 $3.40
Net profit margin 2.3% 5.1%
WACC 8.6% 2.4%
NPV per bbl. ($3.92) $1.78

NPV for 500,000 bbl. ($1,959,764) $890,539

For illustrative purposes only.

1
 ssumes lease rate, insurance and interest are all paid upon purchase of the inventory and assumes no transportation cost
A
because storage.

October 2015 13
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