The search for storage
In the fourth of a six-part series, our trader looks back at a time when oil was the best commodity one could hold
Contango benefits anyone with access to storage because the prompt price of crude is cheaper than crude bought in the future. So it works really well for a refinery that has excess storage.
When managing supply and hedging around a 200,000-barrel-a-day refinery we had crude storage of close to 2m barrels. The company had rarely kept storage completely full but the contango was too large to have empty space, and so a plan was created to secure a long-term ratable supply of crude from a Middle Eastern producer. We wanted to maintain 1.8m barrels of inventory at the refinery. As soon as we were confident enough of securing the supply, we bought front-month futures contracts and sold those we had down the curve to lock in the contango. That enabled us to lower the cost of our inventory every month.
When we priced a cargo to determine the flat price for payment, the structure was to refer to a physical published price index when the cargo was five days out of port on a three-day average. When the three-day pricing arrived, we would have to sell 200 front-month crude futures contracts on each of the three days for a total of 600 contracts. This would cancel out the original long position we had and we'd begin to realise the contango. With crude contango in excess of $1.50 per barrel on a monthly basis, this enabled us to increase refining margins each month. Thanks to the storage capability, this put us at a competitive advantage to those that didn't, all while generating excess returns.
As the price of crude kept rising during the execution of this contango play so did our working-capital requirements. When we began the strategy, the price of crude was about $50/b. So we needed around $90m. But when crude rose to $90/b our financing need went to $162m. My team and I were asked to attend a meeting with the treasury and the chief financial officer. I initially thought that the financing need would have to be justified: a good operator also needs to be a good capital allocator to be successful-so this was expected. But the meeting wasn't anything like I anticipated.
When we sat down, the treasury announced to the group that our financing need went up 80% in the matter of months. As I begin to talk about the returns being generated from increased refining margins, I was quickly interrupted by the CFO. I thought he was going to talk about putting an end to this strategy because he was about to do an acquisition using all the cash on the balance sheet but I couldn't have been more wrong. He leaned across the table and said, "interest rates are basically zero and I have a problem. I'm sitting on $3bn of cash that I'm trying to deploy." It came to me then: he realised oil in a tank or a cargo is virtually the same as cash because our operation revolves around a liquid oil market. I knew what was coming next. "How can we store more crude oil so I can deploy more of this $3bn in cash?" Music to the ears. We went on to secure more crude storage outside our refinery to capture the contango in the market and put our cash to work for shareholders.
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