Boats and (Oil) Hoes: How YOU can play the Contango [Charts Included]

by SwimCamel

I was listening to some late-night financial talk last night per my oil guy Erik Townsend and my Vyvanse prescription decided to give you fuckers a write-up.

So put down the crayons, wipe that drool off your chin, and call in the wife’s bf to help you sound out the big words because we’ve got a lot of syllables to get through.

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Given that our Eses down in Mexico decided to play a little standoff at the OPEC meeting while the Royal Prince and Putin are giving each other fellatio in the back, you might see that oil is most likely staying dirt fucking cheap for the time being.

Being the smart little investor you are, you may be thinking “Hey! I should buy into this – no way oil will be this cheap forever!”.

First off, congratulations!

Do you have your masters in finance? Because you just deduced the most important rule of investing: buy the fucking dip.

Now, this is important, so say it with me out loud: “There. Is. No. Oil. You. Can. Buy. With. A. Stock. Ticker.”

Yep, that’s right. You can’t buy oil at say, $20/barrel and sell it at $50 without taking physical ownership of the barrels.

What this means for you:

Your USO calls aren’t going to capture anywhere near the same return physical oil is going to see over the next few years. In fact, your USO calls are kind of retarded, and that’s ok. Everybody and their mother thinks it’s the best way to play oil in this market.

So, what can you do? Let’s chat.

Oil, Futures Contracts, and Doing the Contango

The way oil is predominantly traded is through Futures Contracts. What are those?

“A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.” [1]

Now, these are kind of similar to options, except for the fact that there is no actual option (not literally, you can trade futures options). What that means is, by entering into the contract, you have a legal ~fucking~ obligation to buy whatever that contract says or settle the amount due in cash (edit: this is a very simplified description – if you’re looking to trade futures, this ain’t it chief). Great, right?

No, not fucking great. What the fuck are you going to do with 1,000 barrels of oil? And no, this oil and this oil are NOT the same thing. No playtime here.

The way these contracts work is you go to the futures and ask for a contract to buy oil at $25/barrel on May 1st. Futures being futures, they’re going to charge you a premium for that contract to purchase at a later date. How much, you ask? I don’t fucking know, typically around $0.20/barrel.

Now, these people selling you this premium, who are on the other side of the contract, are usually one of the commercials. These are people who have literal tanks of oil, and by default, these guys are long oil and short futures contracts.

Since you don’t want 1,000 barrels of that ooey gooey fresh off the Saudi Prince’s nutsack delivered courtesy of Bezos, you can ROLL these contract forward without taking physical ownership of that shit.

So, when you want to roll your May contract for a June contract, who is taking your May contract and selling you a June contract? It is one of these companies holding a shit ton of physical oil, aka the “commercials”.

Under regular circumstances, these commercials are pretty happy to just take that $0.20 contract premium as profit and calling it a day.

Now, let’s catch up to today’s reality.

Oil is fucking everywhere. If you can store it, you’re gonna be printing harder than Daddy Powell.

So these “commercials” KNOW they’re in a position of power since they hold the commodity everyone just knows is going to be worth more by next year. So they tell Mr. Special Retail Investor “You want to roll your May contract to June? Yeah, normally it costs $0.20 for that, but today we’re offering the nice price of $5.99 for the May-June Contract.”

Well, shit. You’re losing practically 1/3 of your investment just to roll that bad boy forward! So you say to Mr. Oil guy “No way buddy, you’re ripping me off”.

Well, remember that pesky “legal obligation” we discussed earlier? The commercials have you dead to rights. If you don’t roll that bad boy further, you get to take on a nice 1,000 drums of crude oil or you have to pay for that shit in cash / close the position (this is again, very simplified). Nobody wants that shit. Looks like you’re gonna roll it forward after all!

Say you went to grab one of these contracts today for $25 and sell in a few months for when oil is $40, you can still lose money on the trade due to these insane rolling premiums.

This is what we like to call contango in the commodities market. What’s contango, you say?

“Contango is a situation where the futures price of a commodity is higher than the spot price. Contango usually occurs when an asset price is expected to rise over time. This results in an upward sloping forward curve.” [2]

Here it is on a graph for you visually inclined folk:

5 Yr. Crude Oil Futures in Super Contango

Right now, crude oil is in Super Contango. It’s like regular contango, but special (like you!).

Now, take another hard look at that graph above. See how it picks up as you move to the right? That’s representing the expectation that oil will be worth more in the future.

The drop off on the right will continue to erode into future months as long as there are storage issues in the oil market. That means the people with storage space are going to be the people making the money in this oil market until the storage issues are fixed.

So, why am I telling you all of this shit?

Well, ask yourself: “Who holds all the power in this super contango world?”

That’s right, it’s the people with the ability to store oil.

So how do you trade this?

Well, since all of this land storage is getting filled up as we speak, where are people going to start looking to store their oil?

Tanker ships.

Boats and /CL Hoes

In addition to land storage, oil companies are looking to store their oil on the tanker ships used to transport their oil.

The owners of these ships see their value in being able to hold a metric fuckton of oil.

Just take a look at the crude tanker rates over the past few months…

2 Yr. Crude Tanker Rates

Oil companies are basically buying oil at the spot rate, loading it on these ships, and buying futures contracts a few months out to lock in a higher price for the oil.

Once they load up the oil, the ship drops anchor and waits for those contracts to come due at the higher price.

As long as there’s a scarcity of land storage for oil, these ships will be used more and more as storage.

These companies are buying the oil today for $20ish/barrel (the “spot” rate) and simultaneously buying selling a futures contract for 4-5 months (or 4-5 yellow dots) later at a substantially higher price*.*

Remember that graph with all the pretty looking yellow dots? They’re playing the rise in that curve.

These future prices are guaranteeing they can sell the oil in August for $32.50, or September for $35, etc.

The kicker is: oil can still be dirt fucking cheap in August or September, but they have a contract to sell that shit at a higher price. No. Matter. What.

There is zero speculative risk for these companies to take this oil, rent out a ship, and have them sit out in the ocean and increase the value of the oil on board.

Check out the crude oil futures spread from May to August:

1 Yr. Light Crude Oil Futures Spreads: August 2020 – May 2020

By August, they’re literally making an extra 50% per barrel, just by sitting out in the ocean.

They don’t even need to know what the future price of oil is going to be – the profit is locked in by the contract.

Better yet, if this spread gets wider – they just call the fucking captain and tell him to sit for another month to lock in even MORE PROFIT, STILL WITH ZERO SPECULATION!!!

As this oil storage issue becomes more prevalent, these shipping companies can start charging more and more for their charters.

Hell, the CEO of EuroNav said they have the potential to earn profit greater than their market cap this year if the rates persist through the rest of 2020 [3]. For you “special” investors, that means their EPS will literally equal the share price. That’s fucking bonkers.

There’s already a 25% percent increase in oil stored on ships [4], but there’s still a lot of room (and time) for profit to be made.

Now, if this Russia and Saudi decide to quit sleeping in different bedrooms and end this price war, obviously the EPS won’t be as attractive, but these companies are still setting up to rake in record profit.

I believe this play is much more tangential than other oil plays and has a lot more room for profit. Not only do you get to play the contango, but you can also profit from both a low price of oil and a high price of oil.

If oil stays cheap, the ships print cash. If oil gets expensive, the ships get back to moving this shit all over the world. Win-Win.

Where to Invest

The most profitable ships for storage and shipping are the VLCC tankers, as they have a capacity of 2MM barrels of oil.

The companies with the greatest concentration of VLCC fleets are DHT Holdings (DHT), Euronav (EURN), International Seaways (INSW) and Frontline (FRO)[4] Over the past month, their stocks have returned +38% for DHT, +21% for EURN, +20% for INSW, and +17% for FRO.

There’s also boosted demand for midsize tonnage tankers, which hold between 1,000,000 and 750,000 barrels. Nordic American Tankers (NAT), Teekay Tankers (TNK) and Diamond S Shipping (DSSI) have a lot of these bad boys.

This is going to be a longer play for me, and I’m planning on holding for 1-2 earnings reports before selling off my positions, as long as oil stays cheap going into summer.

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TLDR: Boats fuck.

EURN $10C 8/21

DHT $7C 10/16

FRO $8C 10/16

NAT $4C 10/16

TNK $17.5C 11/20

SPY $250P 6/19

DISCLAIMER:

I’m not a god damn expert on oil. I’m an IB CRE analyst. There are probably some glaring errors in my analysis. Also, I don’t trade futures – my descriptions are not meant to teach you enough to adequately trade them – it’s a very simplified lesson. As always, do your own homework.

This may look like financial advice, this might even feel like financial advice, but this is definitely not financial advice*.*

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.