Goodbye Contango? Oil's Long March Towards Backwardation

 

The agency’s evident frustration about the slow and uneven pace of rebalancing, and the conflicting signals about whether it is happening at all, is shared by many traders, analysts and investors.

 

“The medium-term outlook for oil still looks challenging with, if anything, balances for 2018 having deteriorated in recent weeks,” hedge fund manager Andy Hall wrote to investors this month.

 

The combination of a trendless market and the growing number of computer-driven trading programmes has made trading strategies based on supply and demand fundamentals increasingly difficult:

 

“Investing in oil under current market conditions using an approach based primarily on fundamentals has therefore become increasingly challenging,” Hall wrote as he explained why he was shutting his main fund.

 

The problem is immediately clear if the current price of oil is compared with prices a year ago. Front-month WTI futures are currently trading at $47.87 per barrel which is almost unchanged from $46.58 on Aug. 16, 2016.

 

Brent prices too are almost back where they were a year ago. Front-month Brent is currently trading around $51.24 which is just $2 or 4 percent higher than on the same day last year.

 

For all the meetings of OPEC and non-OPEC ministers, technical committees and monitoring groups held in the meantime, not to mention the flights and hotel bills, the oil price is right back where it started.

 

Millions of words have been written in the analysis of a market that has gone basically nowhere overall, while sharp price reversals in a trendless market have repeatedly wrong-footed investors.

 

Hedge funds now appear somewhat more confident that rebalancing is finally happening than they were this time last year, but the confidence is not universal, as illustrated by Hall’s pessimistic comments.

 

Hedge funds have a total net long or bullish position in the main futures and options contracts for crude, gasoline and heating oil of 777 million barrels, up modestly from 516 million barrels in mid-August 2016.

 

In one respect, however, the market has exhibited a clear and strong trend, and that has been the strengthening of the calendar spreads for both Brent and WTI (http://tmsnrt.rs/2fKchKu).

 

The WTI futures contract for September 2017 is currently trading at a discount of 77 cents per barrel to the contract for March 2018.

 

By contrast, the WTI contract for September 2016 was trading at a discount of $3.47 below March 2017 at the same point last year.

 

Brent for October 2017 is currently trading 9 cents below Brent for April 2018, compared with a discount of $2.05 for the equivalent pair of contracts this time last year.

 

Prompt discounts for Brent and WTI have been narrowing fairly consistently since January 2016 and arguably since January 2015.

 

Calendar spreads matter because they are related to the balance between supply and demand and changes in the level of stocks.

 

Calendar spreads are more closely related to the market balance than spot prices in the opinion of many traders and academic researchers.

 

Economist Holbrook Working, the father of spread analysis, discovered that the price spread between two months is more closely tied to the basic supply-demand situation than the outright price level.

 

“The July-September spread will be found more intimately tied to the basic supply-demand situation pertinent to it than wheat prices in general seem to be to the basic supply-demand situations pertinent to them,” he noted.

 

Working was examining wheat futures prices between the 1880s and 1930s (“Price relations between July and September wheat futures at Chicago since 1885”, Working, 1933).

 

But the same relationship has been evident in petroleum since the launch of crude futures contracts in the 1980s.

 

Calendar spreads play a critical role in hedging inventories and are also used extensively by experienced traders to speculate on changes in the supply-demand balance.

 

Like flat prices, calendar spreads can still be distorted by short-term noise as traders accumulate and liquidate positions in a herd.

 

But calendar spreads are arguably less noisy than flat prices, and provide analysts and traders with an improved signal to noise ratio compared with price levels.

 

Calendar spreads in both Brent and WTI have been narrowing for well over a year; despite some short-term setbacks, the trend has been consistent and clear.

 

In recent days, the six-month calendar spreads for both Brent and WTI have been trading at or close to their highest level since oil prices slumped in the second half of 2014.

 

Experience shows the crude oil market cycles or oscillates between periods of negative spreads (contango) and positive spreads (backwardation) that mirror periods of over- and under-supply.

 

Oil market crashes are normally accompanied by a shift from backwardation to contango, while recoveries and rebalancing are accompanied by an opposite shift away from contango and towards backwardation.

 

The conventional narrative of oil prices over the last three decades can be fitted fairly easily to observed changes in the calendar spreads.

 

Downturns and subsequent recoveries associated with the East Asian financial crisis of 1997/98, the global financial crisis of 2008/09 and the shale bust of 2014/15 can all be traced out clearly in the spreads.

 

The current upturn in the calendar spreads is therefore a strong signal that the market is rebalancing (or most traders believe it is rebalancing).

 

Calendar spreads have already shifted from a large contango close to flat; if the cycle continues they are likely to shift progressively into backwardation over the next year.

 

FUNDAMENTAL CYCLE

 

The regular alternation of backwardation and contango in the crude oil market suggests a fundamental cause rooted in the behaviour of supply and demand.

 

Deep and wrenching cycles have always been the defining characteristic of the oil industry and are not some incidental problem or aberration.

 

Oversupply and lower prices tend to beget under-supply and periods of higher prices in a repeating pattern that extends back to the 1860s.

 

So it is very likely the current period of low prices and over-supply is already creating conditions for the next upward movement in the cycle.

 

Oil demand is growing strongly in all the major geographic regions, with the exception of the Middle East and Africa, and global demand is increasing above the long-term average rate.

 

The International Energy Agency forecasts that global consumption will grow by 1.5 million barrels per day in 2017 and another 1.4 million barrels per day in 2018.

 

U.S. oil production (crude and condensates) is predicted to rise by 800,000 bpd in 2017 and another 1 million bpd in 2018, according to the U.S. Energy Information Administration.

 

Crude production is also increasing from a number of non-OPEC countries, including Canada and Brazil, in most cases as a result of investments approved before oil prices slumped in 2014.

 

But the pipeline of new non-OPEC non-shale projects is drying up as a result of investments cancelled or postponed since 2014.

 

The oil industry’s spare production capacity is shrinking and set to fall below 1.5 million bpd in 2018, mostly in Saudi Arabia.

 

Global oil inventories remain well above the five-year average, but given the fast growth in consumption the five-year average is likely to prove too low.