It Takes Two to Contango (ICE, NMX)

In the last week or so, everybody seems to have weighed in with an opinion on whether or not speculation is responsible for the rapid recent rise in crude oil prices. Until yesterday, however, the speculation about speculation resembled Mark Twain’s observation that everybody talks about the weather, but nobody does anything about it.

Yesterday, the US Commodities Futures Trading Commission (CFTC) announced that it had reached an agreement with the UK’s equivalent of the SEC and the ICE Futures Europe (NYSE:ICE) under which ICE would provide a daily report on large trader positions in the UK WTI crude oil contract. This report will include long-term contracts as well as the near-month contracts. ICE also agreed to notify the CFTC "when traders exceed position accountability levels, as established by US designated contract markets, for WTI crude oil contracts." In other words, ICE is going to start behaving more like NYMEX (NYSE:NMX).

The CFTC is also trying to increase transparency in the area of index trading, most of which is done by ETF’s. The commission wants to determine if index trading is "adversely impacting the price discovery process" and if additional regulation might be needed to improve transparency for these traders.

Why now? When ICE started trading WTI futures in 2006, the CFTC did nothing to establish any oversight on the trades, claiming it had no authority to review ICE trades. The answer to the question is two-fold. First, it just takes this long to reach agreement on anything. Second, and more important, the crude market is moving into contango, a market condition where future prices are higher than current prices. If the future price of crude is higher than the current price, the current (spot) price has to go up in order to shake loose the physical crude.

Index traders are often blamed for this state of affairs because they never intend to take delivery of the physical oil, instead either taking their profit or, more often, rolling over their contracts for an additional month. This does distort the market for physical oil, but by how much? That’s what the CFTC wants to find out.

One other thing worth noting in the CFTC press release. The commission admitted that it is conducting a "nationwide crude oil investigation into practices surrounding the purchase, transportation, storage, and trading of crude oil and related derivative contracts." It is highly unusual for the CFTC to admit that it is investigating anything. As we pointed out earlier today, if there are bad guys out there, they’re probably be heading for cover soon.

George Soros noted that speculation is driving up energy prices, and we also saw T. Boone Pickens call for $150 per barrel for oil by the end of this year.

Paul Ausick
May 30, 2008