Could Contango scupper the oil market?

According to the insurance broking and risk advisory, marine insurers are increasingly concerned by the issue of ‘contango’ – until now little understood beyond the commodity futures markets – and its potential to affect oil tankers and other bulk carrying vessels.

Among the concerns that cheap oil raises for shipowners and traders are the following, cited in a commentary paper produced by Willis:

  • Potential damage to hull and machinery, following long periods of idleness.
  • Contamination, shortage, and other loss of or damage to cargo.
  • The possibility that oil traders could be held liable in the event of a major oil spill offshore

What is Contango?

The Willis commentary helpfully provides an outline of contango, to explain why it has become an issue since the sharp fall in the price of oil:

People buy futures contracts when the expectation is that the future open market, or ‘spot’ price, will be higher at the time of delivery than the price that was agreed under the futures contract, thereby enabling a profit to be made by that investor when the goods are then sold on.

There is, of course, a risk that market prices at delivery time will be unexpectedly lower than the contractually agreed purchase price. The seller may then be effectively locked into the agreed purchase price, regardless of the actual market or spot price at the time of delivery, unless protected by a ‘stop loss’ or similar clause.

A gradual, long-term increase in prices is the normal way of markets and, in this state, a market is said to be in a state of ‘backwardation’. However, prices don’t always rise and there is no guarantee that the future spot price will be higher at the time of delivery.

When a market has unexpectedly weakened, to the point that the market price for that commodity is lower on delivery than it was when the price was agreed within futures contracts, the market is said to be ‘in contango’.

Traders’ dilemma

This is currently the case with crude oil, a commodity widely traded on the global futures markets, which fell below US$50 a barrel in January 2015 from US$100 only months earlier. Investors, traders and/or their financiers, who had bought ‘long’, suddenly found their market to be in contango.

When the delivery date arrived, their options were to sell and incur a substantial loss or, alternatively, keep it in possession and wait for the oil price to subsequently recover before selling it on again.

The paper highlights two major problems with this approach:

  • Where do traders keep the oil in the meantime?
  • If purchasing the oil under the futures contract requires the trades to obtain funding from banks or other institutions, are those financiers aware of the risks associated with the long-term storage of crude oil at sea?

Not for the first time, a fall in the price of crude oil is being accompanied by a fall in maritime freight prices for the carriage of oil. This is due to there being a glut of oil on the international markets that depresses oil freight rates, which was also the case in 2014.

Oil tanker operators find it more difficult to obtain good charters for their vessels at exactly the time when oil traders are looking for somewhere to keep their newly delivered – or about-to-be-delivered – oil.

The result, says Willis, is that two willing partners enter into what becomes a “maritime contango marriage of convenience”. Oil traders charter idle tanks to store their oil and shipowners find a cheap way of employing their tankers, simply anchoring the vessels and offering them as floating storage units.

Boom and bust

This mutually convenient arrangement unfortunately has several drawbacks, the paper points out. After time, crude oil tends to deteriorate, which can lead to both quality claims and shortage claims. Any ship-to-ship transfers of the cargo that may occur increase the risks of blending and contamination, while a spillage incident could see liability extend beyond the vessel operator and also involve oil traders and/or their financiers, who could be viewed as owners of the oil.

At the same time, marine hull insurers still have memories of economic downturns and shipping slumps in the 1970s and 1980s, when large numbers of unemployed tankers were often moored together. Pollution or damage to both the hull and machinery were often discovered when the vessels were reactivated. History could be about to repeat itself, the paper concludes.

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