Crude Oil Futures Surpass $86: Backwardation Is Back

Just when analysts were starting to wonder about the impact of $85 oil, it goes straight to $86.

OPEC announced that "production by non-member countries is likely falling even as global demand for oil is rising". With a near-term production shortfall estimated at almost 2 million barrels a day, demand is now forecast to rise by 100,000 a day over last year during the fourth quarter.

For those of you who own any of the commodity ETFs that hold crude oil futures contracts, such as (USO) and (OIL), you'll be happy to know that "backwardation" is once again working in your favor, rather than "contango" working against you, as has been the case for much of the last year or so.

The condition that perplexed many commodity investors last year, "contango" - when later month futures contracts are more expensive than expiring near-month futures contracts - has reversed in recent months as shown in the table to the right. The oil futures market is now in "backwardation" which benefits holders of commodity ETFs.

Recall that "contango" makes replacing expiring near-month futures contracts with more expensive contracts for further-out months a losing proposition, all else being equal.

Conversely, in "backwardated" markets, fund managers can replace high-priced near-month contracts (e.g., November at $86.35) with a cheaper futures contracts for 2008 (e.g., March at $82.62) and make almost $4 on each contract that is "rolled-over".

This condition persists today because of the short-term production shortfall boosting near-term prices and the expectation that supply/demand factors will return to normal next year sending prices lower.

The ill-founded, yet perpetual "oil prices will be lower in the future" thinking by traders flies in the face of all that is known about peak oil projections and expected demand as a result of emerging economies around the world (see this article).

The expectation that global demand will remain strong has been bolstered by what many have interpreted as positive reports on the U.S. economy in recent weeks, all of which may contribute to superb performance for commodity ETFs in the months ahead.