The Crazy Way Oil Traders Plan to Make Millions on Oil Prices

By Markets Fool.com

Speculators are often blamed for causing market bubbles. They push asset prices higher till they burst, profit on the way down with bearish bets, and then flip their bets again when the market bottoms. Oil speculators are often blamed for the crazy volatility we see in oil prices. This time has been no different, as oil speculators continue to move in and out of oil in search of big profits. Here's one of the crazier ways traders are looking to make money from the current turmoil in the oil market.

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Switching from paper to the building block of plastic
Oil speculators usually make their money by betting on crude oil futures. These paper, or electronic, bets can be either bullish or bearish and involve buying or selling a futures contract for a specified quantity of oil for a price agreed upon today with a future delivery date. For example, someone bearish on oil could sell short a futures contract, and if oil did indeed fall, the trader could buy back the contract at the now-lower rate and pocket the difference. However, it is important to note that futures traders almost never take physical delivery of the oil, and instead just buy or sell the contracts.

These bearish bets were flooding into the market during the fall of 2014 as oil speculators were growing increasingly bearish on oil prices, with some betting that oil prices were on their way to $0. However, those bearish trades started to flip more recently as traders began to cover their short positions and open new bullish bets, hoping to profit if oil prices quickly rebounded. However, another type of bullish bet is rumored to be in the works where some oil speculators are starting to buy physical oil to have it stored out at sea for a year in order to reap big profits when oil prices are higher in the future.

Source: Flickr user Ian Burt.

Banking on oil's recovery
A recent exclusive by Reutersuncovered a crazy oil trade that's being set up by some of the world's largest oil trading companies, including Royal Dutch Shell Plc . What these large oil traders are doing is hiring supertankers to store oil at sea for up to a year in order to take advantage of the big disconnect between current oil prices and the futures trading price of crude oil for delivery at the end of 2015. It's a strategy oil traders used in 2009 to profit on a recovery the last time oil prices crashed.

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Here's how the trade works. The oil trader leases out a supertanker for up to one year at a discount to the current market lease rate and then fills the tanker up with oil at the current price of around $50 per barrel. It then takes advantage of what is known as contango in the market, as the trader can sell that oil on the futures market, where it is fetching $8 more per barrel for delivery at the end of 2015. The oil trading company can then sit back and wait to collect its multimillion-dollar profit.

A floating bank. Source: Flickr user rabiem22.

The profit potential is pretty compelling. A Very Large Crude Carrier, or VLCC, which can hold 2 million barrels of oil, can be leased for up to 12 months for around $40,000 per day. Meanwhile, oil can currently be purchased for $50 per barrel, which is about $100 million in oil per VLCC. However, the trader can sell oil on the futures market at $58 per barrel for delivery in late 2015, locking in $116 million for the shipment. Even after paying the shipper $14.6 million to store the oil for a full year, the trader can make a $1.4 million minimum in guaranteed profits. However, the traders aren't necessarily selling futures contracts now to lock in a few million dollars in profits as there is a much larger profit potential by simply storing the oil and waiting for a big rally in oil prices, which would allow them to earn a much larger profit.

Investor takeaway
While the average investor can't employ this same strategy, we can still use it as a point of reference as to where we are in the current market cycle. Some of the world's largest oil traders are starting to get really bullish on oil prices by employing a strategy they haven't used since the financial crisis. That suggests these traders see oil prices nearing a bottom as they are buying oil at today's price in hopes of selling it much higher in the future.

The article The Crazy Way Oil Traders Plan to Make Millions on Oil Prices originally appeared on Fool.com.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.