It Takes Two to Seasonally Contango

When crude futures pricing is upward sloping, prices in succeeding delivery months are progressively higher than in the nearest delivery month, investors refer to this type of market as contango. This is the normal state of the crude market, similar to the bond market's normally upward sloping yield curve. However, the economy has been anything but normal lately. Demand estimates for crude seem to be lowering each month. Why are we not seeing backwardation of the crude futures market, where prices in succeeding delivery months are progressively moving lower than the nearest delivery month?

The answer lies in understanding the seasonality of crude prices. There are many factors every day affecting crude pricing. The two most important this time of year supporting contango are the end of refinery maintenance season and the soon arrival of hurricane season.

Refiners of petroleum products take advantage of the end of winter heating season and lower car driving in the U.S.A. to lower production capacity of diesel and gasoline, so that they may perform routine maintenance on their facilities. Now it is time to ramp back up for agriculture, construction and increased summer driving. In order to produce more product, refiners must purchase more crude, which lowers supply and raises spot pricing as well as outer month futures, as end users seek to lock in contracted supply for the summer. We are seeing evidence of this from WTI crude stored in Cushing, OK finally beginning to record lower inventory supply, as the Midwest prepares for agricultural planting.

The other partner supporting crude contango is the weather man. Soon we will be receiving hurricane activity predictions for the 2009 hurricane season. Heavy users of diesel and gasoline in the southern states cannot afford to be without fuel supply due to a hurricane disruption. They begin locking in supply contracts now, with many locking in fixed pricing as well. This activity drives the outer months higher than near month futures.

Traders looking solely at fundamental current over supply will be tempted to short the near month spread. That trade may work if we receive another round of devastating economic news. The higher probability trade is to look at seasonal factors and plan your trading accordingly.