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    Saturday, May 07, 2005


    Oil Inventory Buildup Explained

    There has been a lot of mention in the press recently about the build up in oil inventories and how that means there is no shortage of oil supply. The obvious implication is that as inventories build prices should go down because inventories are in fact supply. This seems perfectly obvious and is the accepted wisdom. IT'S ALSO WRONG.

    It's a case of not seeing the forrest for the trees. Unfortunately for oil bears, inventories are only part of the supply picture. The futures markets are the other supply. With the oil futures market now in cantango (oil for delivery in the future is now more expensive that spot oil) the obvious response is to move oil purchases from the futures exchange to the spot market and hold the oil until you need it, at a cost of around 10c per bbl per month.

    Lets simplify the issue. I make cakes and need flour on a regular basis. I sell my cakes to airlines on a 3 year contract fixed price basis. Therefore if flour prices go up enough I'm going to be selling at a loss. I have two choices, I can enter a futures contract to buy flour every 2 months for the next three years or I can buy it all now and put it in storage. The better option is decided by price. If I can buy flour futures more cheaply than I can buy it at spot & store it, then I would use futures. If on the other hand the futures market was 30% more expensive than buying it now and storing then I would buy it now and store it. Of course if everyone in the flour market just looked at inventories of flour it would look like a huge supply glut, but it needs to be considered in the context of the reduced forward contracts.

    Exactly the same situations exists with oil. American airlines can lock in future oil prices at a higher price than today's spot price using futures or they can just buy oil today and store it. While futures are more than 1.20 above the spot price, annual storage is cheaper.

    Given the contango in the oil futures markets inventory builds are the rational economic result. It's a shame this doesn't get discussed on CNBC.
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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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