Oil Price Rise: Perhaps Wrong, Not Irrational

 

Brent for delivery in May 2016 has risen more than $10 per barrel since early February, while prices for delivery in 2017 are up less than $7 over the same period.

 

The discount for Brent crude delivered in May 2016 compared with the average of 2017, a price structure known as contango, has narrowed from $9 to well under $6 per barrel since Feb. 11.

 

The shape of the futures curve is intimately connected with expectations about supply, demand, stocks and the availability of storage ("Brent contango is hard to square with missing barrels", Reuters, March 10).

 

So the narrowing contango implies the market now expects less oversupply and a smaller build-up in stocks in the months ahead.

 

But market bullishness is at odds with warnings from influential analysts forecasting supply will continue to outstrip demand and stocks rise ("Oil shrugs off Goldman warning about premature rally", Reuters, March 14).

 

It is sometimes said the futures curve is not "forward-looking". If that means the curve is not a simple forecast and is not good at predicting what will happen to spot prices in future, the statement is correct.

 

But the futures market is actually very forward-looking and focused on how the balance between supply, demand, stocks and prices will evolve in the coming months and years.

 

Via the futures curve and the mechanism of financing and storage, those expectations about medium-term supply, demand, stocks and prices are ruthlessly discounted back to the present.

 

Given many market participants believe oil supplies will fall sharply, demand will increase, and stocks will peak and begin to fall later this year, the recent rise in prices and narrowing of the contango are entirely rational.

 

Any other price response would be irrational because it would violate the requirement for inter-temporal consistency.

 

The market could be wrong in its expectations for supply, demand, stocks and prices later in the year and in 2017, but it is being absolutely rational.

 

Spot Prices and Spreads

The price of oil for delivery on a future date (e.g. calendar average 2017) can be thought of as the sum of a spot price (May 2016) and a spread (the price difference between May 2016 and the calendar average of 2017).

 

As a matter of convention, the spread is normally expressed as the spot price minus the futures price (it can just as easily be expressed the other way round).

 

If futures prices are above the spot price, the spread is negative and the market is said to be in contango. If futures prices are below the spot, the spread is positive and the market is trading in backwardation.

 

For example, if the future price is $50 and the spot price is $40, the future price can be analysed as a spot price of $40 plus a spread of $10 contango.

 

Many real trades are arranged this way, with the customer buying (selling) near-dated futures contracts and then adjusting their position by selling (buying) the spread between the near date and the forward one.

 

The advantage of executing trades as two transactions (spot and spread) rather than just one is that it enables dealers and customers to make best use of the greater liquidity in spot contracts.

 

In principle, spot prices and spreads are determined independently and can move separately. In practice, there is normally a high degree of correlation between them.

 

In most cases, rising spot prices will be accompanied by a narrowing of the contango (or a move from contango into backwardation).

 

Conversely, falling spot prices will normally be accompanied by a widening of the contango (or a move from backwardation into contango).

 

This is exactly what is happening at the moment: the market's newfound bullishness is resulting both in a rise in the spot price of Brent and a narrowing in the contango.

 

Prices Move Together

As the market becomes more bullish, the price of contracts for short-term delivery rises faster than the price of contracts for later delivery.

 

The result seems paradoxical since an improved outlook for supply-demand balance over the next few months and years has its biggest impact on the price of oil delivered now.

 

In fact, this behaviour is typical for oil and other commodity markets.

 

Over the period from 1992 to 2016, taken as a whole, there is no correlation between the level of oil prices and the degree of contango or backwardation in the futures curve.

 

High spot prices have coincided with backwardation (January 2008) and contango (May 2008). Low spot prices have coincided with contango (January 1999) and backwardation (April 1999).

 

But the large shifts in the absolute level of prices since 1992 obscure the short-term relationship between spot prices and the shape of the futures curve.

 

A more granular analysis reveals there has been a fairly close correspondence between spot prices and the shape of the futures curve for most sub-periods since 1992.

 

In most cases, higher prices have been associated with a narrower contango, or even backwardation, while lower prices have been associated with a wider contango.

 

This relationship has held in almost all sub-periods since 1992 with the exception of 2005/06 and the first half of 2008.

 

The relationship grows even stronger if we compare the change in prices with the change in the shape of the curve.

 

That makes sense since an increase in spot prices is associated with a narrowing of the contango, and a fall in spot prices is associated with a widening of the contango; both respond to the expected supply-demand balance.

 

Looking Beyond the Glut

Since 1992, changes in the outlook for oil production, consumption and stocks have had the biggest impact on futures contracts near to delivery rather than those with longer maturities.

 

As a result, spot prices have been much more volatile than the price of futures contracts with many months or years to delivery.

 

In the current environment, the oil market is looking past short-term oversupply towards the end of 2016 and 2017 when oversupply is expected to be much less, or there might even be excess demand.

 

Via the storage and inventory financing relationships embedded in the futures curve, the expectation of a future tightening in the supply-demand balance later in 2016 and 2017 is pulling up the spot price of oil now.

 

The market might be wrong to expect the supply-demand balance to tighten by the end of 2016 or early 2017.

 

The short-term increase in oil prices could also be self-defeating if it stimulates more production and thereby perpetuates the oversupply ("New oil order: the good, the bad and the ugly", Goldman Sachs, March 11).

 

But if the market is right to expect the supply-demand balance will tighten later in the year or in 2017, then spot prices have to rise now and the contango must narrow. Any other outcome would be time-inconsistent.