How Citigroup makes hay in the oil market

by Ari J. Officer

Although oil prices have fallen dramatically since July, oil traders are predicting a price hike later this year. Don't be too concerned: this is not always a reliable indicator of higher prices to come at the gas pump, but it certainly highlights a current inefficiency in the oil-futures market.
The oil market has been in what futures traders call a massive contango -- that is, future prices of oil are at extreme highs relative to the current price. Therein lies opportunity: buying and holding oil now, then selling it in the future, can generate an almost risk-free profit. Citigroup has already leased a supertanker to store oil that it will sell later this year.

On the second-to-last trading day for the February 2009 contract at the New York Mercantile Exchange (NYMEX), oil settled with over a $ 22 spread between the February 2009 and February 2010 contracts. In other words, if a company bought oil on the February 2009 contract, stored it for a year and sold it on the February 2010 contract, it would make more than $ 22 per barrel, excluding the costs of the operation. This represents a greater than 60 % gross return!
Since interest, storage and delivery costs should amount to significantly less than the $ 22 spread, the venture would yield a virtually riskless profit, or arbitrage. When the February contract ended trading in late January, an enormous opportunity still existed for arbitrageurs.

Since then, future oil prices have come closer together, averaging just over a dollar between contract months over the next year, or slightly more than the $ 1.02 per barrel per month price tag that Morgan Stanley had reportedly been negotiating in mid-January.
The apparent correction is unlikely to have been caused directly by an institution like Morgan Stanley, but instead by a perception among traders that the average $ 1.25 spread between monthly contracts is reasonable. Of course, leasing a tanker is an extreme measure of storage, and the cost of storing at a more traditional location is much lower; the spread remains irregularly high, and opportunity still exists for anyone with access to storage cheaper than a tanker.

In order to make money from the arbitrage -- and consequently correct the spread -- a company would need capital and storage arrangements for the oil. A firm could borrow money to buy oil in the spot market or the front-month futures contract. More money would be needed to handle margin costs of a short contract in the futures market.
It is possible that amid the current credit crisis, banks have been unwilling to lend money for this trading operation. More likely, though, is that there is limited access to infrastructure for storage. A bank or hedge fund with no such infrastructure has to jump an enormous barrier to entry in order to set itself up for storage -- apparently to the point of leasing supertankers.