January 9, 2007
Same Crowd Behind Oil Rise Now Sells Out
Large Investors Got In, Find 'Rollover' Costs Too High to Stay On
By ANN DAVIS
Crude oil's run last year to close to $80 a barrel drew cries that bullish investors were creating a commodity price bubble. Now it looks like some of the same investors could be accentuating crude's downward slide.
The appeal of holding oil as an investment has changed. Oil itself is losing value -- crude-oil futures yesterday closed at $56.09, down 27% from a July 14 peak on the New York Mercantile Exchange, mainly as mild winter weather reduced heating demand.
Moreover, investors are finding it costs a significant amount of money to keep skin in the game in the oil futures markets during the decline. Unlike the stock market, even if crude goes nowhere in 2007, investors employing a buy-and-hold strategy will actually lose money because of the heavy costs of holding oil futures investments.
"A lot of people came into the start of the year expecting funds and investors to continue putting more money into crude and continue buying commodity futures," says Ben Dell at research firm Sanford C. Bernstein & Co. But, he adds, "if you're losing money month in and month out, you probably don't want to own it."
Oil-futures contracts expire every month. Investors holding the most current contracts have to buy new ones to replace them if they want to maintain their positions. In the past couple of years -- in part, because of the influx of financial investors making long-range bets -- these contracts have gotten pricier the further into the future they are scheduled to be delivered, something known as contango. That raises the cost of keeping a position in the market. It's almost like the difference between walking a mile, and walking a mile uphill.
About two years ago, spot prices of crude were higher than future months, something known as backwardation, which boosted investors' returns every month.
In practical terms, for most investors with oil in their portfolio, the cost of rolling over the expiring near-month futures contract into the one for the next month's delivery is now more than $1.25 a barrel. The price of oil could be unchanged at $50 per barrel, and an investor would still lose 2.5% because of these costs.
The current pain shows up in the Goldman Sachs Commodity Index. It has a roughly 68% allocation to energy futures and fell 15.1% in 2006, thanks in part to the heavy cost of rolling over crude-futures contracts. By contrast, funds linked to the Dow Jones-AIG Commodity Index, which has only about a 33% energy weighting, made 2.1% last year. Other commodity-futures contracts currently aren't as expensive to roll over as oil.
This is affecting large institutional investors, such as pension funds, which have been pouring into commodities in recent years, seeking to diversify their portfolios. A few years ago, they were happy to pay the "roll cost" to hold oil, because its price was rising and canceled out carrying costs in the futures markets.
From 2004 to 2006, according to Bernstein research, investments linked to broad-based commodity-market indexes jumped from roughly $45 billion to $110 billion, with about half of that increase pouring into the energy markets.
But oil's recent slide has given many investors the jitters. Crude oil fell 8.9% in the first two trading days of 2007 and ended last week down 7.8%. Oil fell 22 cents a barrel yesterday, to its $56.09 close on the Nymex.
Nobody is predicting an end to investors' interest in commodities as a way to diversify their portfolios. The California Public Employees' Retirement System, or Calpers, approved a pilot program this past fall to invest directly in commodities-futures markets, and it is one of a growing number of pension funds planning to devote a much larger allocation to the sector.
But these investors also may seek to adjust their allocations to indexes that are less energy-focused than, say, the Goldman index. Because roughly $60 billion is invested in funds linked to the Goldman index, pulling out or switching allocations rapidly could cause further downward pressure on the oil markets, some traders and economists say.
"All the energy centric indices did not do well in 2006. As a result one could expect less money to flow into energy-heavy indices this year," says Harry Arora, head of ARCIM Advisors, a commodities-focused hedge fund in Cos Cob, Conn. Rollover costs are "eating up the returns for the index guy."
Meanwhile, another big question mark is hanging over the market: rising inventories.
Global storage statistics are widely open to debate, and experts disagree on how full inventories are, because a lot of it is controlled by governments and oil refiners and producers.
But a report published last month by Bernstein attempted to quantify just how full storage is in independent, commercially operated storage terminals that traders can use. The research firm's answer as of December: 97% is full, up from 85% 18 months ago and around 70% in 2003.
In pockets of the world where storage is especially full, supplies could flood the market and depress prices, Bernstein analysts contend.
A different set of financial speculators -- including hedge funds and trading firms that buy and sell physical barrels of oil -- have been investing heavily in crude inventories because of the futures market phenomenon.
These speculators enter a contract to sell oil months or years into the future. Then they fill their tanks with oil that they buy more cheaply on the open market. The difference between oil delivered next month and that for August delivery, for example, is roughly $5 a barrel. These speculators pay a few dollars for storage, but still pocket a few dollars a barrel in profit.
Some economists think this strategy could unravel should storage facilities fill up.
Philip Verleger, an independent energy economist who heads PK Verleger LLC, has warned that oil markets could collapse from excess inventory coming on the market and index investors pulling back from oil due to the unattractive economics of holding it.
--Bhushan Bahree contributed to this article.
Write to Ann Davis at ann.davis@wsj.com
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