When news reports mention the price of oil, they are usually referring to the price of a barrel of the benchmark West Texas Intermediate crude, and that price often depends on how much of it is in large storage tanks near the small town of Cushing, Oklahoma. Paying storage costs may prove profitable if oil prices go back up in coming months as some experts predict they will.
Cushing is a town of just over 8,000 people, halfway between Oklahoma City and Tulsa, an important U.S. oil and gas production zone. Cushing is the location of between five and 10 percent of total U.S. domestic petroleum storage and the delivery point for the New York Mercantile Exchange crude oil contract.
Contango is the term oil traders use to describe the profitable price spread that can develop between the spot price of oil and the higher price they can obtain for future delivery. If the future price is high enough, the person selling the oil can pay all the storage costs and still make a good profit.
Oil market analyst Phil Flynn of the Alaron Trading Corporation explains how it works. "You may only pay $40 a barrel, but you could sell it today, lock in a future price much, much higher, just a few months down the road and take advantage of that. You could lock in, per barrel, a $3 or a $5 or, if you could hold the oil long enough, maybe even a $10 profit."
But Flynn says speculators responding to the recent contango have dramatically increased the amount of stored oil and caused the spread to diminish. He says the monthly supply report issued by the U.S. Energy Information Agency Thursday shows an abundance of idle oil.
"We got hit with a flood of crude. Crude oil built like [approximately] over 6.5 million barrels in just one week. We went from a year ago worrying about peak oil and the world running out of oil to having an oil glut of basically historic proportions," he said.
What Flynn is talking about is the way investors, buyers, sellers and speculators react to market fundamentals. But the role of speculators, particularly in the oil market, came under intense scrutiny last year when the price of oil soared to over $147 a barrel.
In May, the International Monetary Fund reported that "speculation has played a significant role in the run-up of oil prices." In June, the Massachusetts Institute of Technology issued a report that called the spike in oil prices a speculative bubble that could not be justified by normal supply and demand factors.
But many of the experts who follow the oil and gas industry closely say the price rise was driven by market forces and that it is likely to happen again. University of Houston Finance professor and Director of the Global Energy Management Institute Craig Pirrong says there is no evidence to support the case against speculators.
"If speculators are the ones willing to pay the high price, they should be the ones who end up holding the barrels. That certainly was not the case during the summer when prices were very high. We would have seen, under those circumstances, sort of a ballooning of inventories during the summer, and that is not what we saw," he said.
Pirrong says demand for oil was driven down by the recession, and that has led to cutbacks in production by many oil companies. Eventually, he says, prices will rise because of the drop in production and the increase in demand that will come with an economic recovery. "Basically, there has been a huge brake put on capital expenditure in the business and exploration, et cetera, as a result of the current financial and economic downturn. But when the economy turns around, and we are back in a situation where capacity has not expanded and demand picks up, then we could see a big spike in prices, and then that will galvanize a whole different political dynamic," he said.
Pirrong says it is all but impossible for anyone to predict the exact timing of the rise, but he says the market is very efficient in setting the price.