When renting a ship to anchor it offshore makes sense (and cents!)

Contango and Backwardation are two terms that confuse many students. But with today's oil markets giving us an historic (and memorable!) example of contango, I trust many more will remember it going forward.

First the fast definitions: (want a better definition? see Investorwords.com)

Contango: when futures price is higher than spot price
Backwardation: when spot price is higher than futures price

Now the story. Oil prices have fallen sharply. In the short term there is more oil than we need. Of course producers will likely adjust (and the economy recover) so most future market participants beleive that oil prices will go up in the future. So why not buy now and hold on to it? Well one problem is that it is not a trivial thing to store oil for long periods of time.

Bloomberg.com: Contango Pays Most in Decade as Shell Stores Crude:

"...traders who bought oil at the $40.81 a barrel on Dec. 5 could sell futures contracts for delivery next December at $54.65, a 34 percent gain."

Now of course there are costs involved (cost of capital and storage costs)

"After taking into account storage and financing costs investors would earn about 11 percent, according to Andy Lipow, president of Houston consultant Lipow Oil Associates LLC."

But where do you store so much oil? With storage facilities in Cushing Oklahoma and elsewhere filling up, companies are renting tankers to anchor off shore holding the oil.

Again from Bloomberg:

"Royal Dutch Shell Plc sees so much potential in the strategy that it anchored a supertanker holding as much as $80 million of oil off the U.K. to take advantage of higher prices for future delivery. The ship is one of as many as 16 booked for potential storage instead of transporting crude, said Johnny Plumbe, chief executive officer of London shipbroker ACM Shipping Group..."

Want to learn more about the contango and backwardation? Check out this teaching video from Bionic Turtle.