Oil's Creeping Backwardation

By Brad Zigler

I-banks are falling like old-growth redwoods in a James Watt-managed reserve; precious metals, defibrillated by fear, have rocketed skyward; and Gulf Coast oil production's been knocked off-line for who knows how long.

Oh, remember that? Remember oil? In case you haven't noticed, the first intimations of post-Ike shortage have crept into the oil futures curve. Backwardation is back. It's tenuous, to be sure, but it's there.

Backwardation prevails when the price of a distant futures contract is below that of an earlier delivery. Yesterday, for example, October crude oil futures settled at $97.88 a barrel. The January 2009 delivery finished up at only $97.72. The January market's "backward" by 16 cents a barrel. Put another way, the spot market (where deliveries are made "on the spot") is 16 cents under January.

Now think about it for a minute. If you have oil to sell, to whom would you rather deal? To somebody who wants it now (or at least by October) or to someone who wants it after New Year's Day? You'll get 16 cents more, and avoid three months of storage costs by dealing your oil in the spot market.

Oil's been in a "normal" market (sometimes called a "contango;" for explanations of these terms, see "The Battle Against Contango") since the beginning of June.

But, overall, oil's tendency has grown more backward over recent years, reflecting an overall decline in available domestic supply. The red line overlaid on the black inventory graph shows the degree of backwardation (readings above 0% on the right-hand scale) since 1985. The dashed black line traces the oil inventory trend since 1985). Backwardation has averaged 33 cents a barrel on a quarterly basis over the past 23 years.

Oil Supply And Backwardation

Well, knocking out Gulf Coast oil production's bound to have a supply impact, you say. So what? Well, backwardation can boost the return of any oil-tracking exchange-traded funds and notes you may have bought, with the notable exception of the MacroShares $100 Oil Up (AMEX: UOY). To see why UOY doesn't join vehicles such as the United States Oil Fund (AMEX: USO), the PowerShares DB Oil Fund (AMEX: DBO) and the iPath S&P-GSCI Crude Oil ETN (NYSE Arca: OIL) at the return-boost table, see "Gold Vs. Oil."

Futures-based indexes, in order to maintain constant exposure to their target markets, must roll their futures positions forward when contracts approach their delivery dates. For an index comprising long futures, an inverted market like today's provides a positive roll yield.

Go back to our example. An index portfolio that's obliged to roll from October futures to January futures would sell October at $97.88 and buy January at $97.72 to maintain its long exposure and, by doing so, pick up a 16-cents-a-barrel return. That gain increases the return (or lessens the losses) sustained from changes in the price of oil during the holding period.

Now, don't get too excited yet. We're only talking about a 0.7% annualized boost so far. Of course, in this market, every little bit helps.

Comments

[Owen:]

At 2:30pm today (EDT) the October/January spread jumped from $0.50 to $1.50. This is a major sea change.

2008 Sep 19 02:35 PM

[Ferdinand E...:]

Very nice and very useful, and 'The Battle Against Contango' is even better.

Ferdinand E. Banks

2008 Sep 21 03:30 AM