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Contango not a happy sign for oil bulls .....

March 14, 2017

 

 

Contango not a happy sign for oil bulls .....

 

ref :- "OPEC's Best Signal of Success No Longer Looks So Promising" , Bloomberg Markets

 

We know about Contangos and Backwardations, right ? Just in case, a very basic refresher ......

 

The terms originated in the mid-19th century on the London Stock Exchange, and although they still apply across a range of markets it's commodities where they are referred to most often. Which is just as well really, as we're looking at Oil and the implications that those two conditions represent for that particular market. So in commodity markets :

 

A CONTANGO is a situation whereby the Spot (or Cash, or Immediate, call it what you will) price of a commodity is LOWER than the Forward (or Future) price. On a chart, this would be represented by an UPWARD sloping line.

 

Obviously, the opposite is :

 

A BACKWARDATION , a situation whereby the Spot (or Cash, or Immediate) price of a commodity is HIGHER than the the Forward (or Future) price. On a chart, this would be represented by a DOWNWARD sloping line.

 

All other things being equal, i.e. if supply and demand were to remain absolutely constant, one would expect future prices of a commodity naturally to be higher than the cash price (a CONTANGO) due to the cost of financing, insurance, storage etc. Occasionally, if the forward premium becomes large enough, an investor may be able to buy the cash commodity and at the same sell it at a higher price for a forward date, reaping more as a return than he would by simply charging interest on his money for the same period, even allowing for insurance and storage. This is known as a "Cash and Carry" trade, and for obvious reasons applies to non-perishable commodities.

 

A backwardation is the less common of the two conditions and often reflects an unexpected near-end squeeze in supply, or boost in demand. For equally obvious reasons, such an occurrence is generally a bullish sign for market price, though not necessarily in the long-term.

 

So back to Oil and Bloomberg's analysis .... After OPEC's "historic" accord to cut production alongside some key non-OPEC producers at the end on November, shorter-term oil prices (say from the present to the end of the year) began to strengthen in comparison to longer-term contract prices. This was the result of expectation that output cuts would reduce global supply to a level below global consumption, and thus eat into surplus inventory hanging over the market. It seemed a good call if you were optimistic about levels of compliance with the new deal.

 

In the event, those levels of compliance within OPEC have been pretty good, even if the non-OPEC signatories to the deal have been less disciplined. The problem has been that with shale oil producers in the game again, rebounding US production and record stockpiles of crude are raising serious doubts about whether the cuts announced in November are working. The fact that the US benchmark West Texas Intermediate crude has broken down through the lower end of its $50 - $55 range suggest that if they are working, they're not working fast enough.

 

Reflecting the fluctuating levels of confidence in the deal this year has been the price difference between the front-end oil contracts and the contracts a year forward. In January the contango narrowed sharply as expectations grew that the production curbs would be successful. By February 21st, the oil market had passed into backwardation, a reassuringly bullish signal. But by last week, the contango had reappeared and is widening to late-January levels as optimism dissipates.

 

As we said yesterday, one imagines that in these circumstances the very least that oil bulls will be hoping for is an extension to the six month deal signed at the end of November. If it is not prolonged throughout the second half of 2017, many feel that the crucial drawdown of stocks will not happen. That's why the backwardation has changed into a contango, according to Torbjorn Kjus of DNB Bank in Oslo.

 

The whole contango / backwardation thing is much more important than being of mere academic interest. Whilst Kuwait is likely to back an extension to the production curbs, Saudi Energy Minister Khalid Al-Falih said last week that the Kingdom was yet to decide on the issue. He is on record as listing a backwardation in futures markets as one of the criteria required to judge whether the cuts were working. A backwardation, which of course is to say front-end prices higher than prices in the future, would encourage traders to deplete stocks and clear the surplus. A contango does the opposite.

 

Since we are back in a contango, that would not seem to bode well for an extension if you take the Saudi oil minister's comments at face value. But that's a big "if", and anyway some respected judges (Goldman Sachs, Bank of America, Morgan Stanley) still feel that the re-balancing of the oil market is on track and inventories will shortly start to decline. Backwardation will once more be the name of the game, and a "steep" one at that, according to B o A. In the opposite camp are people like Commerzbank, who can see prices below $40 in the summer once the Saudis concede that their change of policy in November was a mistaken one.

 

A committee of five producers meet on March 25th to discuss how the curbs are working, with OPEC ministers to meet in May to decide on whether to extend the deal or not. They'll need some evidence of success one feels, and there's precious little of it so far.

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