Stop Counting Crude Inventories

Why the High Prices?

The question then arises: If there is plenty of crude oil available, and sooner or later storage capacity will be exhausted, why are prices still hovering in the $60 to $65 range? Let's turn to our old friends, the long-only commodity index funds. As discussed here last April, the forward curve of crude oil has been distorted by the willingness and ability of these funds to hold and roll long positions regardless of market fundamentals.

How does this work? Let's say the Bombastic Bowtie Fund has a long position of 5,000 May 2006 crude oil futures; this means other players have to have a sum total of 5,000 short positions in May as an offset. They hedge themselves by buying long positions in another month, say June. They know Bombastic Bowtie will be selling its May positions on the fifth through the ninth business days of April and buying June, so they have plenty of time to front-run the BB Fund by selling June and buying July.

The end of the game is that the BB Fund, which encouraged its investors to believe they would be able to harvest endless streams of positive convenience yield by selling May at a premium to June, ad infinitum, now has to sell May at a discount to June. These hot-commodities impresarios are now losing more than $1 per barrel per month in what they were laughing was supposed to be an easy fleecing of the rubes.

Never play poker with a guy named Doc.

The long-only funds thus have pulled off the neat little trifecta of pushing back-month prices higher, distorting crude oil's normal backwardation into contango and virtually mandating the building of crude oil inventories in a capacity-constrained refining system. To paraphrase Churchill, never before have so few ruined so much for so many.

Does this mean you should go out and sell crude oil? No, not at all: Prices reflect replacement costs, and one of the least pleasant ways to spend a morning is wondering how you are going to cover a short position in a news market filled with buyers. It just means you should watch the price and the forward curves carefully, and turn the TV off when they start talking about crude oil inventories.