# A forward dynamic optimization strategy under contango storage arbitrage with frictions

## Behzad Ghafouri and Matt Davison

#### Need to know

• A heuristic approach capturing value from storage in a contango market.
• A dynamic cash-and-carry arbitrage strategy is assessed by simulations under the physical measure.
• Highlights the significant role of the forward curve slope by detailed analysis of the strategy.
• Isolates the contributions of postponing and advancing trades under imperfect rent refunds.

#### Abstract

The goal of this paper is to explain and improve the offshore oil storage trade observed in a contango market using a forward dynamic optimization strategy. The strategy is developed using trades in forward contracts and contrasted with the literature. By simulating forward prices based on realistic May 2009 market conditions, our strategy, when compared with selling the oil on the spot in a base case scenario, gains an extra US$8.99/barrel, which is comprised of US$6.19 generated by the initial forward maximization and US$2.80 achieved by the subsequent trades. The impact of the forward curve dynamics is studied by examining the trading decisions based on the realized slope and mean level of the forward curve. The path of the realized slope and stepwise changes in the slope are found to be able to explain most of the trading decisions. The effect of initial conditions, the frequency with which the position is readjusted and the storage cost are also examined. The optimal frequency depends on the storage cost. Friction is introduced into the problem by penalizing the refund of the storage cost when a decision to advance the short position in time is made, where its influence, which depends on the storage cost, is at most US$1.40.