Wednesday, December 17, 2008

The dark side of contango 

Remember when we bragged about First Fuel Bank and its novel approach to handling gas price risk? They're experiencing some changes.

The St. Cloud fuel bank plans to announce today a new way of selling gas. Consumers in the program can buy gas for 10 cents off the daily pump price, or as company President Jim Feneis guarantees, the cheapest legal price.

It is illegal to sell fuel below a minimum price set by the state.

The program is called a prepaid rolling account. Here�s how it works: A customer opens a First Fuel Banks account, which works much like a gift card, depositing a specific amount of money for fuel purchases.
I've thought about that decision for a few days, and read the company's newsletter. (I have an account with them.) One thing I learned there that I didn't see elsewhere is that if I deposit in this new kind of account -- the firm calls it a "prepaid rolling account" -- you always have the option of moving that money into your fixed price account when that price is acceptable. You can either lock-in at $2.379 or have a rolling account which today prices at $1.599.

Some speculate that the company might have been caught in a bad position with the decline in price. Under the old rules, the firm sold future gas at a date uncertain and should turn around and buy a contract to take delivery of gas at some future, certain date at a price that is a little lower. The margin is their profit. They could also trade future options, hedging the prices as specified here. At present futures prices increase rapidly over the time horizon, so the question for the firm is where to buy those contracts, which in turn sets the price he charges.

The difference has to be more than just the price premium for futures gas (currently running about $.25 to $.30). It also has to cover the uncertainty of the timing of withdrawal. If he buys a futures contract to deliver in June but then demand of people with the lock-in price accounts is low, he is caught with gas perhaps at a lower price than the contract he bought. Rather than accept delivery he closes the position at a loss. He could just accept delivery, but storage is not cheap. He can sell the delivered gas now at the current price and buy a future contract for those who didn't use their locked-in accounts, but the slope of that maturity curve may still be positive, meaning he is still taking a loss.

The slope of that forward curve (called 'contango' when it slopes upward and 'backwardation' when it slopes downward) is what's bugging the firm. It's the opposite of the condition of traders who don't have oil yet.

Phil Flynn, vice president at Chicago-based trading firm Alaron, said the oil contango has created a frenzy for storage space.

�You pay as much as $2 a barrel to store it but you can lock in the profit instantly today and make out like a bandit,� he said.

The scramble for oil storage, combined with reduced demand in the recession, has lifted U.S. inventory numbers to 321 million stockpiled barrels�an 8 percent increase over this time last year, according to the latest report from the Energy Information Administration.

Some companies reportedly are even storing crude in tankers, leaving them at sea instead of delivering their cargo.

This firm already has it. The rolling account is a way to deal with it.

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