Oil, Rig Counts, and Contango

In our subscriber letter this week one of the topics that we discussed was the production destruction as seen in the rig count data provided by BHI-Baker Hughes. They provide weekly oil rig data for the United States and Canada and Monthly numbers for international data.

So what do the numbers show? Well in the United States and Canada the rig count has come down 57% from the highs seen in 9/1/08. This has taken the rig count back to the levels seen in 2002.

US and Canada Rig Count


Internationally the situation is not quite as bad, but it is still bad. Rig counts worldwide have dropped off 35% and we are back to levels not seen since 2004.

International Rig Count Data


After looking at these charts it would seem logical to say that oil is going up as production levels are down so much. Long term this is probably right but in the short and even medium term there are a few major issues that have to be dealt with before oil can have another large bull run.

The main problem is what is referred to as the output gap. The output gap basically says that there is a gap between what we are producing and what we are able to produce. While a small gap almost always is existent right now it is very large. Until the economy actually starts to pick up some steam this gap will remain wide. As the economy produces less and less the need for commodities continues to decline.

This drop in demand for commodities has started to slow but it is still dropping. As we showed a few days ago in our post on port data, world shipping data and therefore world trade has dropped off a cliff.

LA and Long Beach Port Data


Until indicators like the Baltic Dry Index and port data start to turn up, oil and other commodities will have a hard time climbing back anywhere near $100 a barrel let alone the $150 we saw almost a year ago.

Another thing that continues to put pressure on oil is the extreme contango that we have seen this year. Contango in the futures market is when the near month contract is selling at a discount to the farther out contracts.

While a bit of contango is not unusal we have had some extreme readings this year. In fact at one point you could have bought oil in the cash market and by selling the contract six months out you would have locked in a 25% return minus the storage costs.

Over the past few months however the spread has narrowed but is still high enough to cause speculators to build up supply until it is time to deliver. Right now contango is at 10% from the June to September. This means that you could be buying oil now and lock in a 10% return. Until the premium is brought down closer to storage costs there will be a lot of artificial demand which depresses prices and makes it hard for oil to go up in a big way.

4-Month Contango Curve


So until demand picks up and contango comes down we will likely not see a large sustained move up in oil. That being said there are and will be many trading opportunities to the long and short side, but we feel as though a long term bull move is still a ways off.

Happy Trading,

The Macro Trader


P.S. If you are getting value out of our posts, you can do us a favor by linking to us with your site or blog and mentioning The Macro Trader to any of your friends that trade.

1 reply
  1. Jeffrey McLarty
    Jeffrey McLarty says:

    Good stuff Dave, I share your same thesis, whenever the curve lies down…that’s when oil will really start to rip.

    And, I can’t help but notice, you went to a bit of trouble, to plot the oil curve…check out http://www.curvingfutures.com …you can plot the curve, really quickly, from any date you want.

    Jeff McLarty

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