Speaking at the San Francisco Money Show last week, I was asked on several occasions to explain why crude oil prices have doubled since the beginning of the year. Many investors wondered how oil prices could be near USD70 a barrel when US oil inventories remain seasonally high.
The first point to consider is your frame of reference for tracking oil prices. The simple fact is that oil prices never really traded below USD32 a barrel last December; although prices are certainly trending higher year to date, the gains aren’t quite as dramatic as many investors imagine.
The spot price of West Texas Intermediate (WTI) crude oil--the price of oil for immediate delivery--touched a low of USD31.41 a barrel on December 22, 2008. And near-month WTI futures contracts traded on NYMEX changed hands at around the same price in late December.
Television pundits often quote near-month futures or spot prices, but that doesn’t mean the spot price of oil is the most relevant for consumers and producers.
After all, oil producers don’t sell all of their production in the month of December and consumers don’t buy all their oil at one time of the year. What’s most relevant to producers and consumers is the average cost of oil over a longer period.
The purest measure of this “real” price is what’s known as the 12-month NYMEX Strip. There are oil futures contracts expiring in every month of the year for several years into the future. For at least the next year or two of futures there’s plenty of trading volume and liquidity.
To calculate the 12-month strip, we simply average the next 12 months’ worth of futures contracts.
This graph shows that the 12-month crude oil strip fell from around USD100 a barrel in September, briefly hitting lows of USD43 to USD45 in December and February. For the most part, the strip remained above USD50 a barrel, a far cry from that USD32 a barrel low in spot crude.
The strip has rallied roughly 50 percent this year from USD50 to USD75 a barrel--impressive but far less than the 130 percent rally in spot prices from USD32 to USD74.
What accounts for the discrepancy between near-month futures pricing and the strip? The simple answer: Record contango in the crude oil futures market.
Contango is a condition where near-month crude oil futures trade at a significant discount to crude oil futures several months into the future. The best way to illustrate contango is with a graph.
To generate this graph, I took the price of crude oil futures expiring 32 months in the future and subtracted the near-month futures price. Futures expiring 32 months from today represent the price you would pay today for crude oil to be delivered 32 months in the future (May 2013).
I plotted this graph over a trailing 10-year period. Over this timeframe, the average value for this spread was negative USD2.76 a barrel; in other words, long-dated crude oil futures generally have traded at a discount to near month futures. This is the opposite of contango, a condition known as backwardation.
A quick glance at this graph shows just how unusual market conditions were at the end of 2008 and early 2009. In late December, contango in the WTI futures market reached record levels, exceeding USD35 a barrel. Because spot prices were around USD40 a barrel at the time, contracts expiring a few years in the future were trading at a 100 percent premium to spot and near-month futures--a truly staggering figure.
Backwardation in the crude oil futures market typically indicates that oil market fundamentals are tight, but should ease in coming months. For example, after Hurricanes Katrina and Rita, near-month crude oil futures spiked as traders fretted over supply disruptions in the Gulf and damage to refining and transport infrastructure. There were some temporary shortages of crude and gasoline in certain markets because of pipeline and refinery closures.
At the same time, most traders expected conditions to ease once pipelines were inspected and brought back online. Thus, near month futures traded at high levels relative to longer term futures--the market was in backwardation.
Contango implies that near-term oil market fundamentals are bearish but investors still expect longer-term improvement. In the late 2008 through early 2009, investors faced rapidly rising US oil inventories and an accelerating decline in global oil demand--fundamentals looked bearish.
More important, the US and global credit markets were in a state of near-total dysfunction. The lack of demand, excess supply and near cessation of business activity due to weak credit market conditions pushed down near-month futures and sent contango to record levels.
Since early this year, contango in crude oil futures markets has declined to around USD8 a barrel, still a historically stretched level. The simple recovery in contango to more normal levels accounts for about USD27 a barrel of the USD31 a barrel rally in spot prices since the beginning of the year.
The above graph shows two other instances when crude oil market contango was high relative to historic norms: late 2001 through early 2002 and late 2006 through early 2007. On both occasions, near month oil futures rallied over the ensuing year, closing the contango condition.
In the case of 2002, near-month crude rallied from around USD22 to USD32 a barrel, eliminating the contango. And in 2007, crude rallied from around USD60 to near USD100 a barrel, closing the USD10 in contango that existed at the end of 2006. It’s hardly a big surprise that history is repeating itself: Near-month futures prices are on the rise, again bringing crude oil market contango back into line with historical norms.
Bottom line: The depressed crude oil prices at the end of 2008 and early 2009 were the real aberration--not the current quote. Those depressed prices reflected unusually weak near-term fundamentals and historic imbalances in the futures curve. Much of the subsequent rally has simply been an unwinding of those imbalances.