NEW YORK - The deepening discount of near month oil futures contracts against later months is scaring investors off simple passive funds that helped drive big returns during crude's six-year rally, Erik Simpson, managing director at Vantage Energy Hedge Fund said on Friday.
Passive index plays found big profits during much of oil's rally to over $147 a barrel in July by selling front month futures contracts and buying cheaper second-month contracts -- something possible only in a market structure called backwardation.
Oil prices have collapsed to $35 since then as the recession hits fuel demand, pushing front month futures into a discount to later months -- a market structure called contango which forces investors to pay out rather than profit when shifting cash from one month to the next.
"The investment is extremely uncompelling for the big commodity investor that has been trying to buy oil since 1998 and 2000," said Simpson. "The shape of the curve is getting toward levels of extreme contango."
Pension funds and other big investors -- many of which got into commodities through passive indexes -- are already reassessing strategies for 2009, while speculator open interest in crude hit 1.68 million in the week to December 9, off nearly 200,000 from end-2007 levels.
Strong growth in demand from China and other emerging economies stretched supplies starting in 2002, sending commodity prices up and drawing in billions in fresh investment cash to the asset class.
Crude spent much of that period in backwardation, helping to keep investors who pushed billions of dollars into commodities through the simple passive plays in the money.
As demand has collapsed, inventories in developed economies have begun to build, adding further downward pressure on prices especially for front-month futures.
"There is a glut in the front end of the markets, we're basically out of storage in the United States," said Simpson.
January crude on the New York Mercantile Exchange traded at $35.38 a barrel on Friday afternoon, while February crude traded at $42.28 and the March contract at $45.00.
The steep drop in crude prices prompted oil cartel OPEC to agree to the deepest production cuts ever as part of an effort to drawdown rising inventories and send prices higher.
Still, this might not be enough to convince investors to rush back into oil.
"The problem with that though is that while fundamentally there are probably some reasons that this is near bottom, the cost of carry to hold that investment is around 30 percent on an annualized basis for someone who wants to hold the investment and roll it each month," said Simpson.
"Even if oil just sits here they will lose 30 percent just holding."
Passive index plays found big profits during much of oil's rally to over $147 a barrel in July by selling front month futures contracts and buying cheaper second-month contracts -- something possible only in a market structure called backwardation.
Oil prices have collapsed to $35 since then as the recession hits fuel demand, pushing front month futures into a discount to later months -- a market structure called contango which forces investors to pay out rather than profit when shifting cash from one month to the next.
"The investment is extremely uncompelling for the big commodity investor that has been trying to buy oil since 1998 and 2000," said Simpson. "The shape of the curve is getting toward levels of extreme contango."
Pension funds and other big investors -- many of which got into commodities through passive indexes -- are already reassessing strategies for 2009, while speculator open interest in crude hit 1.68 million in the week to December 9, off nearly 200,000 from end-2007 levels.
Strong growth in demand from China and other emerging economies stretched supplies starting in 2002, sending commodity prices up and drawing in billions in fresh investment cash to the asset class.
Crude spent much of that period in backwardation, helping to keep investors who pushed billions of dollars into commodities through the simple passive plays in the money.
As demand has collapsed, inventories in developed economies have begun to build, adding further downward pressure on prices especially for front-month futures.
"There is a glut in the front end of the markets, we're basically out of storage in the United States," said Simpson.
January crude on the New York Mercantile Exchange traded at $35.38 a barrel on Friday afternoon, while February crude traded at $42.28 and the March contract at $45.00.
The steep drop in crude prices prompted oil cartel OPEC to agree to the deepest production cuts ever as part of an effort to drawdown rising inventories and send prices higher.
Still, this might not be enough to convince investors to rush back into oil.
"The problem with that though is that while fundamentally there are probably some reasons that this is near bottom, the cost of carry to hold that investment is around 30 percent on an annualized basis for someone who wants to hold the investment and roll it each month," said Simpson.
"Even if oil just sits here they will lose 30 percent just holding."
