Will Crude Futures Flip Into Backwardation?

| About: The United (USO)
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Summary

Price recovery underway.

Price contango shrinking.

Case for backwardation.

Case for contango.

Crude futures prices have risen by 89% since February 11th, the day before a select group of OPEC ministers met with the Russian oil minister and announced the "freeze" concept. Because the idea did not contemplate removing one barrel of production from the world market, I concluded that the upward move was due to "headline risk," which altered the risk-reward of being short. Recently, I published an article showing just that: short-covering by money managers was by far the largest change in futures market positions and was highly correlated to price changes since then.

This past month, a confluence of unrelated circumstances in Africa, the Middle East and North America resulted in crude oil production outages. The combined total of oil production outages around the world this month is about 3.4 million barrels a day (mmbd), and oil futures prices rose by another 7.6 percent since April 28.

During this price recovery, the term structure of the crude futures price strip has changed dramatically. The front month contracts have gained considerable compared to the long dated months. What was a steep contango has become a small contango.

Crude futures shifted from backwardation to contango on November 20, 2014, one week before the ill-fated Thanksgiving OPEC meeting in which the market share battle was declared. The largest contango in fact was on February 11, 2016, the day before the price recovery began (see graph).

One question on traders minds is, will the market soon be in backwardation? While I cannot predict when the outages will clear, I present the case for and against a transition to backwardation.

"Normal Backwardation"

In Treatise on Money (1930, chapter 29), economist John Maynard Keynes argued that in commodity markets, backwardation is a normal market situation, and so he referred to it as "normal backwardation." Producers of commodities are more prone to hedge their price risk than consumers, and so there is more selling than buying interest after the nearby month.

All things being equal, this also makes sense from an insurance risk standpoint. Producers want greater certainty for their revenues and are willing to pay a risk premium. Buyers are will to take the risk, but they want to be paid a risk premium. As a result, futures prices are inherently underpriced.

Although oil inventories are near historic highs, the 3.4 million barrel per day (mmbd) oil disruptions globally means that the supply-demand balance has shifted from a current surplus to a deficit. Moreover, taking a sharp look at U.S. supply/demand fundamentals for crude, since the futures contract is WTI trading in Cushing, Oklahoma, reveals a pronounced shift, according to the latest Short-Term Energy Outlook (STEO), published by the Energy Information Administration (NYSEMKT:EIA).

Crude oil production was most recently estimated to be around 8.8 mmbd. The EIA projects it will drop 700,000 b/d to 8.1 mmbd in September, a very fast drop.

Crude production is not the sole source of new supply, however. Other supply, such as Natural Gas Liquids, are used in the production of finished petroleum products and must be taken into account, as I explained here. EIA projects this category to increase in the months ahead.

As a result, total crude plus other supply will still drop, but not as fast as crude production alone. EIA projects a drop of about 600,000 b/d.

Net crude imports are expected to climb over the next few months. However, because of the wildfires in Canada and the fact that Canada is the main source of U.S. imports, refiners may need to shift supply sources to make this happen.

Crude inputs to refineries, which represents the domestic demand for crude, are projected to rise to 17 mmbd at the peak of the refining season this summer. That is up about 800,000 b/d from the latest weekly estimate.

Putting this altogether implies a crude stock draw which has started.

It appears U.S. crude oil inventories have peaked. Although they will remain relatively high over the balance of the year, they are headed lower. This supports a shift in futures prices to backwardation and that term structure does not reward the building of stocks.

In addition, prices in the outer months are already above $50 per barrel, and I provided testimony from various company sources that they will complete wells at that price threshold. And so, as Keynes explained, it is logical to expect more hedge selling pressure to develop in the deferred contracts, pushing them lower than the front month contract.

Case For Contango

As mentioned in the introduction to this article, short-covering by managed money (specs) was primarily responsible for pushing prices up since mid-February. The "headline risk" behind that, owing to the "freeze" concept, has been completely vanquished by the positions taken by Saudi Arabia and Iran. Were it not for the oil outages, much of the risk premium due to that factor would have been reduced; that is, short-sellers who had covered their shorts, would have increased their short positions, in my opinion.

Secondly, the large cumulative size of the disruptions is more likely to drop rather than increase. Canadian tar sands production will resume, even if it is delayed for more weeks.

Third, because prices are above $50 beyond the first month and hedge short positions have increased, I doubt that U.S. production will drop as fast as the EIA had predicted. Their production model is not price-sensitive.

Finally, I performed an historical analysis of daily crude futures prices from 1985 to the present, when prices were greater than $40, $50, $60 and $70. The contango price structure prevailed two to three times more often than the backwardated structure. Although that is not specific to current market conditions, it seemed worth thinking about why that has been the case.

$40

$50

$60

$70

9%

8%

8%

8%

Backwardated

27%

24%

19%

15%

Contango

37%

32%

27%

22%

Total

Note about table above:

I selected days when prices were $40 or more (37% of days), then calculated if they were also in backwardation (9%) or contango (27%). Then selected when prices were $50 or more, and so forth. I was surprised to find prices primarily in contango at these levels.

Conclusions

Based on the EIA projections for U.S. crude fundamentals, a strong case can be made for the market to flip to backwardation. However, much of the risk premium inherent in nearby futures prices can dissipate once the intensity of current disruptions lessens.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.