What's Cooking with the Oil Price Contango?

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contango or forward premium is the order. Furthermore, the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

Since the Eighties, WTI has ruled the global crude oil market. As it is produced and refined in the US, the world s largest consumer and importer of crude oil, it has been widely accepted as the best indicator of global demand-supply. Nymex WTI contract is the largest market for this crude oil.

Brent oil is pumped out from the North Sea and shipped to Europe, Russia and parts of Asia. Oil from Europe, Africa and the Middle East flowing to the West tends to be priced relative to this oil, i.e. it forms a benchmark. However, large parts of Europe now receive their oil from the former Soviet Union, especially through Russia.

Traditionally, Brent traded at a discount to WTI because it is less light and less sweet.

From the charts below it can be seen that the differential between the near/front month contract between WTI and Brent started appearing toward the end of 2008. Also note the Dec09 contracts have shown very little differential.

So what’s cooking?

One explanation that I have come across is:

…it is becoming more expensive because the North Sea oil fields are getting depleted. But that doesn’t explain its premium over WTI. On the other hand, WTI was clearly over-supplied. The problem was created by the very nature of the WTI market. The WTI market has a large number of independent producers who sell their crude based on posted price. The oil is then brought into Midland and sent to either towards the Gulf Coast refining areas or towards Cushing, Oklahoma. Cushing is an oil-trading hub and the delivery point for NYMEX light sweet crude oil futures contracts. Due to pipeline logistics, once the oil flows outwards from Midland towards Cushing, WTI can only go in one direction: towards Chicago.

So if refineries in Chicago want less oil, you can’t divert the oil towards other places where there might be more demand. In the last three months, several factors led to large supplies of oil flowing into Cushing.

However, demand for crude has come down as it is reported that the refineries' off take has fallen given that the refining margins are wafer thin or negative. This has reflected in the pump prices going up.

Now what’s happening in Cushing? NYT explains:

A year ago, oil producers and refiners could not move their products fast enough to meet growing world demand and chase rising prices. Now, with demand and prices slumping, they are sitting on 327 million barrels at tank farms around the country, particularly at Cushing, Okla., a major storage hub and a crossroads for pipelines. That is more than 40 million barrels more in storage than this time last year, and more than 30 million barrels higher than the five-year average. The mounting buildup has come during the last 100 days or so, as consumption of oil fell behind imports and domestic production.

In this context note that:

The International Energy Agency predicted that the worsening global economy will leave demand at 85.3 million barrels a day _ 0.6 percent lower than 2008. Demand last year is estimated to have slid 0.3 percent.

The IEA says it lowered its forecast because it has nearly halved its estimate for global economic growth to 1.2 percent.

U.S. petroleum deliveries _ a measure of demand _ fell 6 percent to 19.4 million barrels a day last year, with declines for all major products made from crude, according to the American Petroleum Institute.

The Organization of Petroleum Exporting Countries has also lowered its energy demand forecast for 2009, saying in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009 from the previous year.

The demand destruction is further evidenced by the fact that:

From the Indian Ocean to the South Atlantic to the Gulf of Mexico, giant supertankers brimming with oil are resting at anchor or slowly tracing racetrack patterns through the sea, heading nowhere.

The ships are marking time, serving as floating oil-storage tanks. The companies and countries leasing them for that purpose have made a simple calculation: the price of oil has fallen so far that it is due for a rise.

Some producing countries are trying to force that rise by using the tankers to withhold oil from the market, while traders are trying to profit by buying cheap oil now to store and sell at a higher price later. Oil storage has become so popular that onshore tank capacity is becoming scarce.

…noted that a trading company could buy oil at the spot price of nearly $40 a barrel, store it and sell a contract to deliver it in a year for about $60. “You pay between $6 and $10 a barrel to store it, and you can make $10 a barrel”... “That’s why Cushing is filling up rapidly and people are leasing tankers..."

… With storage tanks filling up onshore, private and national oil companies, refiners and trading companies are storing another 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years, according to Frontline Ltd., the world’s largest owner of supertankers.

The different players have different reasons for storing oil, whether onshore or offshore.

As to why the futures are trading at such premiums the reasoning is that:

…OPEC has announced 4.2 million barrels a day of production cuts since September, moves that investors have so far ignored. But markets may be anticipating those output cuts will start to tighten oil supplies later in the year…

“The OPEC production cuts are going to take time to widdle away the build up in inventories," ... "But if compliance is high, that could support prices looking further out..."

Coming back to the question of WTI and Brent the question that arises is: “How can oil around the globe be priced by a small US location, which doesn’t have a safety valve to deal with a few million extra barrels of oil?” or should Brent become the benchmark as I understand it has no such logistics related bottlenecks, and therefore is Brent now reflecting a truer picture?

The jury is still out on this.

Disclosure: No Positions.

Comments

[Perry1961:]

The financial crisis started in the US. Have no fear,Brent prices aren't far behind. Oil bulls should head for Cushing,with anything that will hold oil.

Jan 20 03:04 AM

[Jake Berzon:]

Thanks for the explanation - it makes sense. I was starting to wonder why WTI has remained so cheap for so long vs. Brent. I have never seen this happen before!

What is your prognosis on the price level stabilization? Will the price of WTI oil rise to match futures contracts, or will all this storage cause a further drop in prices that will spill over to Brent?

Jan 20 03:09 AM

[Tradesense:]

Jake

Consensus estimates on oil prices are still very bullish. These estimates indicate a USD82/bbl and USD90/bbl for 2010 and 2011, respectively, and even reflect a higher price assumption at USD96/bbl for 2012. Looking at the history of consensus estimates, it is found that current oil price estimates are higher than what they were one year ago. While in September 2007, the oil price assumption averaged USD62/bbl for 2009-12, the current assumption averages 43% higher at USD89/bbl. The current high oil price assumption it appears reflects high oil prices seen in 2008.

I believe further scope exists for these assumptions to come down, as oil prices continue to remain lower going forward. This is similar to what had happened after the 1979 oil shock, when oil price assumptions continued to fall with price assumptions drifting lower during 1982-97.

Historically, every recession since the early 1970s has followed a period of high oil prices. However, the excessive leverage and under-pricing of risk are also central to the current downturn. In the current down turn, oil prices played what has been described as a ‘contributing role’ by reducing consumer spending and confidence, and placing the burden on many businesses, both large and small.

In the early 1970s, the global GDP was growing at annual rates of 6-9%. The so-called first oil shock, which took place in 1973, restricted the GDP growth in 1974-75 to less than 2%. Similarly, the GDP grew at 6-7% during 1976–79, the year of the Iranian revolution and the accompanying second oil shock. For 1980–82, the average growth was again below 2%. From 1983 to 1988, it recovered to around 6%.
After 1980, oil prices began a 6-year decline, which culminated with a 46% price drop in 1986. This was due to reduced demand and over-production, which caused cracks in OPEC’s unity. Oil prices remained on a low trajectory during 1983-2003. Prices saw a small spike again in 2000. In 2001, the GDP growth registered a similar drop.

The highest average annual oil price prior to 2004 was USD36/bbl in 1980. For 2004, 2005, 2006 and 2007, the annual price of WTI crude averaged USD41/bbl, USD56/bbl, USD66/bbl and USD72/
bbl, respectively, as the GDP continued to grow at 6-7% over this period.

Oil prices remained low for 20 years after the 1981 recession.

Given the global synchronization of this slowdown of much higher severity and the lack of consumer spending power (which was a savior in the past) I would tend to believe that soft oil would prevail for a reasonably long time fluctuating between $25-30 to $50-55.

WTI's importance will remain unless US relative consumption falls drastically. It will help if Cushing can address the logistics problem.

I'am sure there will many other views which could throw more light to it.



On Jan 20 03:09 AM Jake Berzon wrote:

> Thanks for the explanation - it makes sense. I was starting to wonder
> why WTI has remained so cheap for so long vs. Brent. I have never
> seen this happen before!
>
> What is your prognosis on the price level stabilization? Will the
> price of WTI oil rise to match futures contracts, or will all this
> storage cause a further drop in prices that will spill over to Brent?

Jan 20 07:40 AM

[scfranklin94:]

You're comparing Feb WTI vs. Mar Brent; you should be comparing. Mar WTI 42.67 vs Mar Brent 46.57. So the Brent premium is there, but it isn't $10.

Jan 20 09:01 AM

[toobad41:]

West Texas Intermediate is no longer a guage of the international oil market. The market is artifically depressed because of the glut of oil thus there are many refinery shut-down's or curtailments nation wide. Storage (inventory) is not the name of the game.

Jan 20 09:48 AM

[Urbane Gori...:]

Coincidentally, Gazprom turned off the natural gas flow to Europe on Jan 3rd, which appears to be the point when the Brent prices deflected from WTII. When natural gas is unavailable, the power generation in Europe switches to oil from natural gas. That puts immediate pressure on the local source of oil...Brent.

jegan

Jan 20 07:14 PM

[MILESCFA:]

On Jan 20 07:40 AM Tradesense wrote:

> Consensus estimates on oil prices are still very bullish...

> The highest average annual oil price prior to 2004 was USD36/bbl
> in 1980. For 2004, 2005, 2006 and 2007, the annual price of WTI crude averaged USD41/bbl, USD56/bbl, USD66/bbl and USD72/
> bbl, respectively...

I looked at the IEA's supply and demand for oil when someone wrote a very bullish view on oil rebounding rapidly and in a big way. Supply and demand just don't support the big bull case (small, maybe) - neither s/d increases or decreases rapidly, or in economic terms, oil is very price inelastic.

However, has anyone noticed how the prices cited above coincide with all the money flowing into commodity hedge funds (I mean, anyone besides Mike Masters of Masters Capital)?

Jan 20 09:01 PM

[User 355191:]

Natural Gas supply to Western Europe was never affected by the cut from Gazprom. It only affected the power generation in some Eastern European countries (Serbia). The power generation capacity from Oil in Europe is very limited and is not connected to the natural gas supply. These mostly very old plants are nowadays only producing when we have price spikes which never was the case this year.

On Jan 20 07:14 PM jegan ;-) wrote:

> Coincidentally, Gazprom turned off the natural gas flow to Europe
> on Jan 3rd, which appears to be the point when the Brent prices deflected
> from WTII. When natural gas is unavailable, the power generation
> in Europe switches to oil from natural gas. That puts immediate pressure
> on the local source of oil...Brent.
>
> jegan

Feb 11 01:26 PM