How Citigroup Makes Hay in the Oil Market

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Of course, much of this storage is owned by private companies, which might be unwilling to rent space. But why didn't those firms increase their own inventories to make money from the arbitrage?

A year ago, the vast majority of storage at Cushing was operated by BP, ConocoPhillips, Enbridge Energy Partners, Plains All American, Semgroup, Sunoco Logistics Partners and TEPPCO. These are all transporters and suppliers of oil, which tend to benefit from higher oil prices. More accurately, when prices are volatile, these companies will perform better if prices are generally increasing.

Buying the front-month contract tends to increase its price, while selling the back-month contract tends to decrease its. As the prices come together, the arbitrage opportunity will disappear. Because the back-month contracts have less volume, the effect of selling the back month is greater than the effect of buying the front month. Taking advantage of the arbitrage opportunity would do more to lower prices long-term than raise them short-term.

There is a clear conflict of interest here. All the companies with the resources to correct the large oil spread might hurt other profits by affecting oil prices. The truth is that the open interest in the oil-futures market is greatly overshadowed by the much larger size of the physical oil market. The number of barrels of oil that could be stored profitably might not actually be that large, as it would take relatively little volume to correct the spread and eliminate further opportunity. The profit from storing a few million barrels is infinitesimal compared with the sustained profits from higher oil prices.

Is it really true that oil suppliers and transporters skipped out on an easy arbitrage in order to ensure higher prices? Maybe not, but the fact that this could be a consideration holds a lot of weight in the oil market. Regardless of the oil companies' actions and motives, traders on the NYMEX have priced oil as if Cushing were at capacity.

The larger question, of course, is not why traders failed to correct the spread but why the spread became so large in the first place. At the top of the market in July, oil was in contango, but not absurdly so. As prices fell, the front-month contracts fell faster than the back-month ones. An economist might argue that this was a consequence of the expectation of a short-term slump in demand and a gradual recovery. More likely, the unwind of speculators' long positions — which were more concentrated in the nearer months, as opposed to the long positions of hedgers extended further into the future — led to an accelerated decline in the front months. It also represents the presence of short sellers who jumped into the bear market: speculators trying to profit from oil's decline. Speculation created an enormous arbitrage opportunity as oil bottomed out in recent weeks.

On the final day of trading for the February 2009 contract, the spread narrowed by almost $6. Indeed, the February contract went up while all the other contracts on the NYMEX went down. Typically, the spread widens during the last trading days as long-contract holders sell the near month and buy a back month to roll over their positions. This time, short sellers covering their positions by buying back oil proved to be the dominant speculators in the market. Whatever the case, the price of the front month increased while all others decreased. This shows that speculators have a significant impact on the market through activities like short-covering. Now that prices have come off the lows and stopped moving into new territory, traders' personal accounting issues are no longer driving the market, and oil prices have consequently stabilized to a more justifiable contango.

While speculators may have produced an intensified contango, it is interesting that oil suppliers were not quick to correct it for an easy profit, particularly during the last trading days of the February 2009 contract. More and more we have seen that the oil-futures market is too small and susceptible to manipulation, setting prices that do not match the traditional framework of supply and demand.

The price of oil on NYMEX has become a reflection of the storage situation at Cushing, Okla., rather than a reflection of the oil market. Given that Cushing is currently storing enough oil for less than two days of total American consumption, it is absurd that its storage should carry such weight with the price of the commodity. NYMEX trading may not directly dictate the prices set in all physical transactions, but it is certainly true that hedgers protecting against increases in oil prices have paid higher premiums because of it.

Read "A Brief History of Fuel Efficiency."

See photos of Canada's "oil in the sand."

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