Flattening Oil Contango: Is It a Bullish Sign? 22 comments
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Starting about ten months ago, if you had access to oil storage tanks plus enough financial resources, the sky was the limit to buying spot crude oil and selling a year or so forward on Nymex. For more than six months, it was a highly profitable trade when the spread between the near-month and forward contracts was about $10/bbl or more with a return of more than 15% (Fig. 1, click to enlarge). During the super contango phase of late 2008 and early 2009, the spread was so ridiculously wide that the rate of return was close to 70% at one point in time. 
Why is the Contango Flattening?
You may recall that the spread gap opened just a few weeks after Lehman Brothers (LEHMQ.PK) failed and AIG (AIG) required a capital infusion. Those few who had a role in taking advantage of the super contango ended up boosting the spot oil price back to a more normal relationship to the outer months. This is one of the reasons that the contango in the WTI Nymex crude market has weakened over the last few months quite substantially (Fig. 2, click to enlarge). 
In addition, the weakening contango in Nymex might also be related to an investigation by the Commodities Futures Trading Commission (CFTC) and other authorities into long-only funds and ETFs. Since much of the long-only fund buying has taken place in the futures, their liquidation in response to the regulatory investigation is likely putting downward pressure on futures contracts, narrowing the contango in WTI Nymex.
Reviewing Market Fundamentals
Spot prices becoming more expensive relative to future prices will typically encourage refiners to convert crude into product drawing down crude inventory. It will also dis-incentivize speculative crude storage hoarding, and provides incentives for producers, and OPEC in particular, to start some of the shelved projects. The same goes for non-OPEC producers. So a weakening contango, if sustained, will likely help normalize the crude supply and inventory levels. 
However, the demand outlook remains dismal. The U.S. EIA just reported domestic consumption of liquid fuels and other petroleum products declined by almost 6.3% year-over-year during the first half of the year, one of the steepest declines on record. Total consumption is now projected to decrease by about 4% year-over-year in 2009 and grow only 1.4% in 2010 (Fig. 3, click to enlarge). The latest EIA weekly petroleum report also showed the year on year U.S. gasoline inventory was 23.1% higher, while distillate fuels rose to their highest level since January 1983 (Fig. 4, click to enlarge). 
Is it Bullish?
A narrowing contango is traditionally seen as a bullish sign for the crude market, but investors interpreting the current flattening contango as such should probably beware. Based purely on market fundamentals, crude oil should be priced around $40 a barrel. At the moment, the murky economic and demand outlook is not yet supportive of the current oil price levels. The risk is likely on the down side in the near term, as any further increases in crude prices are less likely without an increase in consumption.
Goldilocks of Oil Prices
Nonetheless, once economic recovery returns, demand may jump sharply and then the existing oil reserves would come under pressure. In addition, crude prices of late have been tied to the equity markets, which have been trading irrationally on a weak dollar rally. Amid expectations of a further weakening U.S. dollar against emerging markets currencies, coupled with the current seemingly satisfactory oil price levels to both consumers and producers, crude price could well be sustained at around $60 to $75 a barrel range quite possibly through 2011 or 2012 barring any Force Majeure events.
Disclosure: No Positions
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As you can see, the pick up from China will likely be offset by the decline in develped countries, so the growth is not as robust as it was before this global recession. Since oil is currently overpriced, in my opinion, the overall growth along with other market factors could still contiue to support the $60-75 level.
Thanks for your comment.
On Sep 24 07:25 AM chap08 wrote:
> You say that "the demand outlook remains dismal" and then go on to
> prove this by listing US domestic figures. Is such a US-centric view
> of oil still valid? Asia on its own consumes more oil than the US,
> and that's where we can expect most of the future demand to come
> from.
If $60+ is going to last for another 3 years, how is that NOT driven by fundamentals?
If oil is able to drop in price to $40 without any help, large segments of the alternative energy strategy may get crushed by the who cares faction, that will put off non-economic concerns until tomorrow. If the oil price spikes are few and far enough in between going forward, oil's price volitility, again, becomes a barrier to entry for alternatives (and drilling). The producers' nations wanting $60 to $70 without any leverage doesn't mean it will happen. And consumers wanting cheap and stable energy will not be willing to pay to allow a real oil alternative to build enough foundation to stand on its own. Thereby, if and when oil gets $40 cheap, unless growth rebounds quickly, the price stays there for a while.
Speculators in alternative energy will grow tired of waiting for oil to peak....again.....and slowly money will move back into oil speculation, which..... guess what...... raises oil's price....and...creates a boom in alternatives. This is a glacier pace speculative cycle that affects many other investment endeavors.
So if oil staying between $60 to $90 allows alternatives to gain a significant foothold, oil will have had a cap and floor put on its price. Then all growth and commodity inflation will be muted for a long, long time. Hmmmm......We are in Soros territory.
further?
"...So if oil staying between $60 to $90 allows alternatives to gain a significant foothold, oil will have had a cap and floor put on its price. Then all growth and commodity inflation will be muted for a long, long time. Hmmmm......We are in Soros territory..."
On Sep 24 09:30 AM change is the only constant wrote:
> Thanks Dian. I am not sure if this was your intent, but you have
> just defined how oil can continue to spur or cap growth based on
> volitility. And you have also outlined how speculative money will
> move energy trading in the near term.
>
> If oil is able to drop in price to $40 without any help, large segments
> of the alternative energy strategy may get crushed by the who cares
> faction, that will put off non-economic concerns until tomorrow.
> If the oil price spikes are few and far enough in between going forward,
> oil's price volitility, again, becomes a barrier to entry for alternatives
> (and drilling). The producers' nations wanting $60 to $70 without
> any leverage doesn't mean it will happen. And consumers wanting cheap
> and stable energy will not be willing to pay to allow a real oil
> alternative to build enough foundation to stand on its own. Thereby,
> if and when oil gets $40 cheap, unless growth rebounds quickly, the
> price stays there for a while.
>
> Speculators in alternative energy will grow tired of waiting for
> oil to peak....again.....and slowly money will move back into oil
> speculation, which..... guess what...... raises oil's price....and...creates
> a boom in alternatives. This is a glacier pace speculative cycle
> that affects many other investment endeavors.
>
> So if oil staying between $60 to $90 allows alternatives to gain
> a significant foothold, oil will have had a cap and floor put on
> its price. Then all growth and commodity inflation will be muted
> for a long, long time. Hmmmm......We are in Soros territory.
Note in Table 12. U.S. Petroleum Balance Sheet, Week Ending 05/22/2009 the value of Gross Product Imports (5) --- gasoline imports --- 3,167.
Note the last EIA report listed the Gross Product Imports as 2,592 .
At the current price of about $2.50/gallon in the United States, refiners outside the United States that sell their product in Euros have no desire to export their gasoline. Thus, even with substantial crude stockpiles in the United States, I estimate their will be a shortage of gasoline in the United States ( stockpiles of gasoline below 190 MB before the end of the year ). This estimate is based upon a net decrease of about 500,000 thousand barrels per day gasoline imports into the U.S.
The result is the following: If the dollar doesn't get 'strong' then gasoline prices will go back to $4/gallon in about three months.
Why?
I agree that fundamentals should have crude lower, but I don't understand that statement. There is no supporting framework in your analysis for how you arrive at such a precise target. I've heard that number thrown around, but you don't provide facts to support it.
The physical relationship achieved through a shrinking contango does not seem obvious here, as front month prices should trend lower as inventories continue to build, but really have not done so.
The only sense I can try and make from what has happened to crude prices is that they have been like many other asset classes, in that they have been subjected to the expectation of a major and nearly immediate economic recovery. I also feel that investors are not that much more enthusiastic about oil's prospects for appreciation out to February as they are about it today, given how fast assets have appreciated in such a short period of time, and hence are only willing to pay as much for oil six months out.
Like many, I am guessing about the oil market, and the market will likely keep us guessing.
On Sep 24 09:04 AM GrantQ wrote:
> Sorry if i'm missing something obvious here, but if market fundamentals
> say $40, but you still expect $60-$75, how are you accounting for
> the difference?
>
> If $60+ is going to last for another 3 years, how is that NOT driven
> by fundamentals?
As stated in the "Goldilocks of Oil Prices" section of my article, the $60 to 75 oil price range seems to be the "happy zone" for everyone from consumers to producers, and where OPEC will most likely defend. Therefore, I see this range sustainable in the medium term amid expectations of weakening dollar, economic recovery, and OPEC defense, among other factors.
Fossil fuels are projected to still supply 70-80% of world energy needs well into the foreseeable future by various studies even if alternative energy use got trippled or more. Until alternative energy becomes economically competitve and gain wide consumer acceptance to really take significant market share from conventional sources, we will need all kinds of energy sources alternative and conventionals. Thanks for your comment.
On Sep 24 09:30 AM change is the only constant wrote:
> Thanks Dian. I am not sure if this was your intent, but you have
> just defined how oil can continue to spur or cap growth based on
> volitility. And you have also outlined how speculative money will
> move energy trading in the near term.
>
> If oil is able to drop in price to $40 without any help, large segments
> of the alternative energy strategy may get crushed by the who cares
> faction, that will put off non-economic concerns until tomorrow.
> If the oil price spikes are few and far enough in between going forward,
> oil's price volitility, again, becomes a barrier to entry for alternatives
> (and drilling). The producers' nations wanting $60 to $70 without
> any leverage doesn't mean it will happen. And consumers wanting cheap
> and stable energy will not be willing to pay to allow a real oil
> alternative to build enough foundation to stand on its own. Thereby,
> if and when oil gets $40 cheap, unless growth rebounds quickly, the
> price stays there for a while.
>
> Speculators in alternative energy will grow tired of waiting for
> oil to peak....again.....and slowly money will move back into oil
> speculation, which..... guess what...... raises oil's price....and...creates
> a boom in alternatives. This is a glacier pace speculative cycle
> that affects many other investment endeavors.
>
> So if oil staying between $60 to $90 allows alternatives to gain
> a significant foothold, oil will have had a cap and floor put on
> its price. Then all growth and commodity inflation will be muted
> for a long, long time. Hmmmm......We are in Soros territory.
I guess you have not seen the latest inventory report from the EIA ?? Let's get Tyler from Zero Hedge educate you:
Oil Plunges As Inv Build Does Not Confirm Rosy Econ Forecasts tinyurl.com/lxwne5 // (posted yesterday at zerohedge.com)
On Sep 24 10:40 AM ryanclarke wrote:
> The weak dollar as compared to the Euro has resulted in a substantial
> decrease in European gasoline imports to the United States.> unless the dollar rebounds. Given the Fed's weak dollar policy I
> conclude your anaylsis is wrong.
The next 2 years could be tough for natgas, but price should rebound from the current historical lows, as production cuts materialze on a larger scale and expected demand pick up. Thanks for your comment.
On Sep 24 09:48 AM scudman wrote:
> hey dian, if your theory is correct--when or how might this begin
> to lift natural gas as well--they've not been linked for many moons
> -- do you see the two marching in step anytime soon?
Speculation in crude now, however, means those hoarding waiting for prices to rise, are being trapped by falling demand. The flip from contango to backwardation may mean a steep drop in crude prices to rebalance inventory with demand. How long, and where, the crude lower prices stick will depend on the strength of the "recovery" underway and the continuing market penetration of alternative energy products.
then when she finally makes a prediction, it's wrong.
in article dated 9/14 she wrote:
"....So, there will likely be a painfully lower gas price on hand in the next 6 to 10 weeks or so"
and
"....we could be looking at a brief sub zero price scenario"
and
"traders should brace themselves for quite possibly the darkest days in the next 2 months for the natural gas market"
in the 10 days since then, nat gas has gone from $3.30 to $3.99 (20% higher).
babble on
Also your 18 mil barrels of crude needed to make 9 mil of gasoline is wrong. It only took 14.7 mil to make 8.9 mil for the Sep 18 week.
Gasoline isn't going to $4 in 3 months. If it does, then we will be in the Greatest Depression ever.
On Sep 24 10:57 AM ryanclarke wrote:
> The EIA data is available at www.eia.doe.gov/oil_ga...
> .
>
> Note in Table 12. U.S. Petroleum Balance Sheet, Week Ending 05/22/2009
> the value of Gross Product Imports (5) --- gasoline imports ---
> 3,167.
>
> Note the last EIA report listed the Gross Product Imports as 2,592
> .
>
> At the current price of about $2.50/gallon in the United States,
> refiners outside the United States that sell their product in Euros
> have no desire to export their gasoline. Thus, even with substantial
> crude stockpiles in the United States, I estimate their will be a
> shortage of gasoline in the United States ( stockpiles of gasoline
> below 190 MB before the end of the year ). This estimate is based
> upon a net decrease of about 500,000 thousand barrels per day gasoline
> imports into the U.S.
>
> The result is the following: If the dollar doesn't get 'strong' then
> gasoline prices will go back to $4/gallon in about three months.