The Winners of the Black Gold Contango

July 29, 2020

It’s still early to say just how long the glut in oil prices will last. But no matter the length, there is one clear winner.

Oil has snapped back up to $40 from its crazy lows earlier this year. But for most producers, that’s not nearly high enough to reach profitability again.

Recently, I touched on the other side of the industry and its own troubles. Refineries like Valero Energy Corp. (NYSE: VLO) are facing their worst prices in a decade.

But what about midstream? Oil and gas production is still not an easy place to be. Refineries and gas stations are failing. So, you might think that the companies that tie these parts of the industry together are also suffering.

Actually, quite the opposite.

There are a term oil traders use to describe situations like we’re seeing today: contango.

Contango simply refers to the prices in the futures market. When investors believe oil will recover at a later date than today, they can buy longer-term futures contracts. This pushes the price of later-dated contracts much higher than short-term ones.

The situation back in April shows this in action.

With lockdowns and economic terror at their highest points in 2020, no one wanted to take delivery of oil. So, May futures contracts actually entered negative territory.

But the further out you went, the more stable the prices were. Oil was still trading above $30 for July contracts when May’s were negative.

While this might all seem like some paper trading technique used by high-end speculators, it isn’t. There is a real-world equivalent to contango: storage.

Midstream’s Strength in Good Times and Bad

Companies like Enterprise Products Partners LP (NYSE: EPD) and Magellan Midstream Partners LP (NYSE: MMP) operate in a strange no man’s land in the oil and gas industry.

These are pipeline services companies that are in charge of shipping oil and gas from producers to refiners. And from there, they ship oil and gas products to consumers.

But they also have another business. They can rent out storage. When a producer isn’t happy with the price offered on the open market, they can pay EPD and MMP to simply store it until prices recover.

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That’s the physical contango market. But here’s the beautiful part of this for these midstream companies. They don’t take the risk of getting it wrong.

They don’t own the oil and gas held in storage. They simply charge fees for the use of their facilities. So, as you can imagine, the oil contango trade has been spiking all year.

Prices are down from $60 at the beginning of the year. So, many producers are forced to pay storage companies like EPD and MMP until oil and gas recover.

If it doesn’t, or at least doesn’t more than $40 for an extended period, the producers take the losses. Midstream companies just collect checks.

But what happens if oil does recover and the demand for storage goes down? Well, here midstream companies make even more money.

You see, storage is only a secondary part of their businesses. They make more money in the transportation of fuels. If oil recovers, producers will rush whatever production they have left through to consumers as fast as possible.

Midstream companies bank more fees with more demand.

So, you might expect companies like these to have done well this year. The truth is, they haven’t.

The businesses have. But with so many bears in the oil and gas trading circles, they have seen their shares unfairly discounted.

This is a huge opportunity. These companies will recover. And they should do it soon.

An Added Benefit While We Wait

Because of their partnership status, they pay out large distributions to shareholders. This year’s drop has only made those payments more impressive.

Right now, EPD pays 9.7% and MMP pays 10%. Good luck finding that anywhere else in this zero-rate environment.

Both companies are more than able to cover those insanely high payments through this contango business. If and when oil and gas prices recover, their profits will grow even more.

This is a great entry point for both companies. Even a mild recovery to where they were prior to the 2020 meltdown would give you a solid short-term profit of 67% or so.

And in the meantime, you can bank these 10% yielders while everyone else is missing the contango rally.

To your prosperity,

Joshua M. Belanger
Executive Publisher & Founder

Joshua M. Belanger
Joshua Belanger is founder of CounterVest and the editor of Hot Money Trader. He has been providing ordinary investors blockbuster returns since 2008. In 2018, the average return of Hot Money Trader beat the markets by over 15%

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