(MarketWatch) - The fast-shrinking price gap between crude-oil futures for prompt delivery and crude destined for delivery months down the road is backfiring on investors who bet big that the gap would widen.
At the same time, the trend is playing nicely into the hands of investors in oil exchange-traded funds, who stand to benefit from the loss of a somewhat obscure hidden cost along the lengthy supply chain.
That cost loops back to Cushing, Oklahoma, the delivery point for light sweet crude contracts traded on the New York Mercantile Exchange. As a weak economy slowed demand for oil, crude supplies backed up at Cushing, with sellers wanting to hold barrels in anticipation of a price rebound. This, in turn, put further pressure on near-term prices as storage became a problem.
Late last year, this situation resulted in the January crude contract trading at a $8.49 discount to crude for delivery in February, a record between two successive months' contracts, and a situation known among futures traders as contango. The discount was so steep it got the label "super contango." See related story.
Demand for storage prompted oil supertankers around the world to drop anchor and become floating oil storage tanks.
But since December the contango gap has dropped sharply to less than $2, as Midwest refiners slowly shipped oil stored at Cushing to their refineries.
That drop has been a blow to the mostly institutional investors who took part in these complex trades, betting that the gap would stay wide. But for individual investors, who tend to simply bet on the direction of a single-month contract, the drop in the price gap has brought some relief from a so-called "roll-yield" cost that hits exchange-traded funds.
This cost, which is caused when ETFs that hold the front-month oil contract move their holdings into the next month contract, can penalize holders of funds like the United States Oil Fund , the biggest oil ETF.
The narrowing of contango will help reduce this cost, the fund says.
That relief may soon disappear, however. As summer driving season approaches, analysts expect contango to change course again, although not to approach its earlier record.
"You really have demand destruction now," said Tariq Zahir, managing member of New York-based trading firm Tyche Capital Advisors. Weak demand is pressuring the price of the front-month contract, he said.
"But you get a little bit support [in the following months] with the hurricane season coming up, and of course the driving season coming up, that can keep the price further out high," he added.
Zahir said he is betting on a wider contango going into summer. But he said he isn't trading the front-month contract because of "higher volatility," instead choosing to enter a contango trade between the July and August contracts.
As of Thursday's close, contango between the front-month June contract and July contract stood at $1.45 a barrel, while contango between the July and August contract stood at $1.26.
On Thursday oil ended up 77 cents, or 1.6%, to $49.62 a barrel. Front-month contracts have gained 11% so far this year
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