The New York market for residential and commercial heating oil is traditionally tight in the winter months when demand exceeds local production and supplies are supplemented from storage and inflows/imports from outside the region. Coming into winter this year inventory levels were above normal for the time of year and market prices are in contango (a condition where future prices are higher than today) – encouraging further storage. Today we explain how the result is an extension of traditional seasonal storage trade opportunities and a shortage of available inventory capacity.
Traders have long taken advantage of seasonal demand patterns for energy by buying when consumption and prices are low in the off-season then storing until supplies become tighter during the high demand season and selling at a profit. Northeast natural gas traders routinely used to take advantage of higher winter prices for gas that they buy cheap in the summer months and inject into storage – selling at a premium when winter weather pushes prices higher. That strategy is getting harder these days because abundant production in the northeast from the Marcellus and the Utica is keeping winter prices lower (as we pointed out earlier this week in “I Walk The Line”). Another popular trade based on the same principal involves purchasing heating oil during the summer in the northeast - placing it in storage and selling when winter demand pushes prices higher. In both cases (natural gas and heating oil) the success of the trade relies on seasonal demand outpacing local production during the winter and pushing up prices enough to cover the trader’s storage costs and a margin to boot. The seasonal heating oil trade is popular in the New York region because the CME/NYMEX heating oil futures contract requires delivery in New York harbor – meaning that participants have a pretty efficient hedging tool to lock in the seasonal spreads to profit from the trade. This year however high crude oil and refined product inventory levels in a generally oversupplied market are weighing on prompt prices versus those for future deliveries - a market condition known as contango that we have discussed several times this year (see Skipping The Crude Contango). In New York the current heating oil market contango is providing an additional opportunity for traders to profit from storage outside the traditional summer/winter seasonal play.
Figure #1 shows the growing contango in heating oil futures since September. The blue line in the chart represents the contango spread (in $/Bbl) between CME/NYMEX heating oil futures contracts for delivery 6 months in the future and the prompt contract and the red line is the contango spread for 12 months out. The 6 month contango spread reached its highest point in 5 years (since 2010) this October ($4.32/Bbl) and was still at $3.63/Bbl at Wednesday’s close (November 25, 2015). The 12-month contango closed at a record $8.31/Bbl this Tuesday and narrowed to $8.08/Bbl Wednesday. The current 6-month contango numbers are not much different to the kind of spreads that could be achieved from the traditional seasonal play we just described over the past 10 years. For example the seasonal spread between heating oil futures prices for August delivery and prices for delivery the following February during the period from March to July each year averaged $3.67/Bbl over the period from 2005 to 2015. But Wednesday’s 12-month contango numbers – representing a $8.08/Bbl winter/winter spread between this December and next November – offer a better return than the typical seasonal play even after storage costs are factored in.
Here’s how a trader could (theoretically) profit from the 12-month contango trade based on these prices. The play involves purchasing physical heating oil in New York harbor (the delivery point for the CME/NYMEX contract) at the same time as selling an equivalent volume of futures contracts for delivery 12-months later in November 2016. The physical heating oil would then be stored at a NYMEX approved New York harbor terminal until it is delivered in November 2016 in order to fulfill the futures contract obligation. The futures hedge locks in the contango price spread and the trader has only to pay the storage cost. In this case the 12 month contango spread is $8.08/Bbl and storage is likely to cost somewhere around 50 cents/Bbl per month – or a total of $6/Bbl netting a trade profit of $8.08 – $6 or $2.08/Bbl. The six-month trade would only net a much smaller $0.63/Bbl because the storage cost ($0.50 * 6 months = $3.00) eats up most of the $3.63/Bbl contango spread. It should also be noted that a trader is likely to incur other costs such as finance and broker fees that can reduce the trade profits. (If all that is still gobbledygook to you we provided a more detailed explanation of how the same contango trade works for crude oil at Cushing, OK in “Skipping The Crude Contango”).