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What Is Oil Contango And How Will it Impact the Energy Patch?

With the U.S. pumping the most oil it has in three decades and OPEC refusing to dial down production, oil prices have collapsed to their lowest point in six years. This, combined with the expectation that crude prices will rally in the foreseeable future, has created a considerable incentive to place oil in storage.

As a result, oil prices are caught in a phenomenon known as “contango,” which means that the current spot price is lower than the future price as represented by futures contracts.

Now what?

This creates a considerable incentive for traders and speculators to enter the market and purchase oil to store now and then sell in the future at a considerable profit. The end result is yet another threat to oil prices and Canada’s energy patch. 

You see, contango has resulted in a groundswell of oil being placed into storage. U.S. oil inventories are now at their highest level in 80 years, with about two-thirds of total U.S. storage capacity being utilized.

However, with contango set to continue for the foreseeable future, there has been no slowdown in the amount of oil entering storage, thus creating fears that remaining storage capacity could run out by June this year. If this were to occur then a flood of oil could hit the market, driving prices even lower. Some analysts are predicting that WTI could fall as low as US$30 per barrel.

There are signs, however, that this threat is not as severe as initially thought.

Sharply lower crude prices create a considerable incentive for refiners to boost refinery utilization rates because of the opportunity for higher profit margins on offer.

Furthermore, as storage capacity diminishes, storage fees continue to rise, in some cases quite dramatically, from a few cents per barrel to over a dollar at some facilities in recent months. This creates a disincentive to store oil, while also providing an incentive for other storage providers to enter the market.

So what?

The impact of contango on oil prices is difficult to judge because of those mitigating factors.

Nonetheless, those energy companies best positioned to minimize any potential impact are the integrated energy majors and those that have hedged a significant proportion of their future oil production.

Integrated energy major Suncor Energy Inc. (TSX:SU)(NYSE:SU) has one of Canada’s largest refining businesses, and as a result, is well positioned to weather any further drop in oil prices. Since oil prices collapsed it has focused on boosting its refinery utilization rates, which are now at an impressive 95%.

Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG) is also well prepared to weather lower crude prices. It has over half of its 2015 oil production hedged at $89 per barrel and a third of its 2016 production at $84 per barrel.

Surprisingly, one Canadian energy company, Enbridge Inc. (TSX:ENB)(NYSE:ENB), will profit from this phenomenon. It has the largest oil storage facility at North America’s most important storage location, Cushing, Oklahoma. As a result, as the demand for storage grows and storage fees rise, Enbridge’s earnings from that facility will grow.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Matt Smith has no position in any stocks mentioned.

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