Crude oil has been facing bullish and bearish factors over recent weeks. After many months of hyper volatility, oil has settled into a trading range. Huge price swings took the price from over $107 per barrel in June 2014 to lows of $26.05 on Feb. 11 before the price recovered to over the $50 level in December 2016. Last week, in an article on processing or crack spreads, I pointed out that this area of market structure was not totally supportive of a higher oil price at this time but that the trends in refining spreads showed some promise for the future. Over the past week, crack spreads have moved in opposite directions. The gasoline crack spread in March moved lower from $11.96 per barrel on Friday, January 27 to the $11.30 level and the heating oil processing spread has rallied from under $15.50 to the $16.20 per barrel level on Feb. 2. The price action in the crack spreads were marginally supportive for crude oil given that the API and EIA reported another round of inventory increases for gasoline and heating oil last week.
This week I am going to hone in on another important piece of the crude oil puzzle to help us uncover clues when it comes to the path of least resistance for oil prices. Term structure or the forward curve in oil is the price differentials between different months in the oil futures market.
Term structure can offer directional clues
To understand term structure it is important to define two terms that commodity traders use all the time, contango and backwardation. Contango is a market condition where deferred prices are higher than nearby prices. Backwardation is a market condition where deferred prices are lower than nearby prices. A contango market tends to be a market that is either in equilibrium or in a glut or oversupplied condition meaning that current supplies are equal to or higher than current demand. A backwardation market tends to be an indication of as deficit where current demand is higher than current supplies.
There are different degrees of contango and backwardation and the spreads between nearby and deferred prices can move dramatically over time. Therefore, it is the trend of the nearby versus deferred prices, or the spreads, that can provide valuable information about the path of least resistance for commodity prices from a fundamental perspective. In the crude oil market, many professional traders express their market view by positioning in spreads. A bull spread is a position whereby a trader will buy nearby crude oil and sell deferred crude oil. A bear spread is a position whereby a trader will sell nearby crude oil and buy the deferred futures month.
A condition of tightening occurs when the spread narrows or the nearby contract outperforms the deferred futures price. Tightening tends to be a bullish signal for the underlying price as demand for immediately delivery is higher than demand for delivery of deferred periods. Loosening tends to be a bearish signal for the price of the commodity as oversupply means that there are abundant supplies for immediate delivery.
Therefore, when a contango narrows it tends to signal positive overall price action in a commodity. When crude oil was heading to multiyear lows last year at this time, the contango increased to over 25% in the nearby NYMEX futures contract versus the one year deferred price. As crude oil has moved progressively higher since, the contango has declined, the spread has tightened.
Oil spreads are moving around on NYMEX futures
As the chart of the March 2018 minus March 2017 NYMEX crude oil futures spread highlights, at first the spread narrowed from $3.28 at the end of November 2016 moving to a low of $1.38 on December 2. However, since then the spread has moved higher, crude oil term structure loosened (the contango moved higher) and it was trading around the $2.32 per barrel level on Feb. 2. However, the contango of 4.3% is much lower than the over 25% seen last year at this time on the nearby versus one year NYMEX crude oil spread and the chart shows that the spread has been making lower highs since December. Source: CQG
The chart of the June 2018 minus June 2017 NYMEX oil spread illustrates that the spread has moved from the $2.60 per barrel level in the middle of November 2016 to lows of a 54 cent backwardation on December 12. However, the spread has loosened since and was trading at 79 cents on Feb. 2 or a contango of 1.4%. Like the March-March spread, one year term structure from June 2017 has been making lower highs.
While recent price action in the spreads indicate a higher contango, the trend is still lower. Resistance in the March one year spread is around the $3.80 level and in the June spread it is at $1.42. If both spreads were to trade above those levels it would negate the pattern of lower highs and could tell us that the tightening trend is in jeopardy.
Some of the recent upside pressure on the nearby March one year spread is likely the result of the record high open interest in NYMEX crude oil futures. We will soon enter into the roll period where speculative positions will move their risk from March to April futures. Since there are many speculative longs in crude oil, the upward pressure on the spread could continue as they sell nearby March positions and replace them with long April positions. It is likely that the roll will cause the contango from March 2017 futures to increase in the short term. The April 2017 versus April 2018 NYMEX spread was trading at the $1.98 level on Feb. 2 or 3.7%, lower than the March-March one year spread.
Oil spread tighten in Brent
The major factor that caused crude oil to move back above the $50 level on nearby NYMEX and Brent futures was the decision by OPEC to cut production at the cartel's November 30 meeting. All signs are that OPEC has cut at least 1.5 million barrels of output per day in January. As of Feb. 1, the April 2017 versus April 2018 Brent spread was trading at the 76 cent level or 1.09% while the June 2017 versus June 2018 Brent spread was at close to flat, the prices of both contracts were virtually equal. As you can see, Brent spreads are tighter than NYMEX WTI crude oil term structure and that is because while OPEC is cutting production, U.S. output of WTI crude oil has increased as the higher price has encouraged producers to pump more in the shale regions of the United States. As of January 27, 566 oil rigs were operating in the U.S., an increase of 15 rigs from the previous week and some 68 rigs in operation above last year's level.
While U.S. production is on the rise, both NYMEX and Brent spreads have been trending lower since early December which is a supportive sign for crude oil.
The Trump effect on crude oil
President Trump campaigned on a platform of energy independence for the United States. To achieve that goal, the administration intends to reduce regulations and encourage energy production by moving forward on logistical projects like the Keystone and other pipelines. The President is serious about his energy initiatives as he his cabinet appointments reflect his desire to increase U.S. oil output and reduce production costs. The appointment of Rex Tillerson as Secretary of State and nominations of Rick Perry as Secretary of Energy and Scott Pruitt as head of the Environmental Protection Agency are testament to the President's intentions. President Trump plans to not only make the U.S. energy independent but to create a production environment where the nation can export energy to the rest of the world and compete with the other major world producer including Russia, Saudi Arabia as well as other OPEC producing nations.
On face value, an energy renaissance in the United States would appear bearish for the price of crude oil. After all, more production will increase global inventories and pressure prices. However, while the U.S. production increases, OPEC output is moving lower. At the same time another initiative of the administration is to embark on a massive infrastructure rebuilding project which will increase demand for energy for construction and provide fiscal stimulus to the economy. Any increase in GDP could cause the demand for energies like crude oil to rise. Increases in the demand side of the fundamental equation for crude oil will put upward pressure on prices.
The bottom end of the range is likely to hold but open interest is a concern
As the monthly chart highlights, open interest has increased to the highest level in history. Open interest is the total number of open long and short positions in NYMEX crude oil futures at over 2.2 million contracts . There is a two-fold reason for the increase in open interest. First, the move above the $50 level on NYMEX crude has encouraged a restart of production across the U.S. Oil production became uneconomic when prices fell to lows of $26.05 last February but at double that price level lots of wells are coming back on stream. The increase in the total rig count has caused many producers to seek to lock in prices above the $50 per barrel level thus increasing open interest. At the same time, the trend in oil has been higher since last February and the production cut by the cartel has encouraged speculative long positions. A combination of increasing hedging on the short side and increase speculative longs has lifted open interest to an all-time high.
When markets overextend when it comes to the total number of long or short positions, it tends to signal a reversal in trend. Like a game of musical chairs, when speculators become too emboldened on the long or short side the market tends to run out of more buying or selling and the trend reverses sending those speculators scurrying for the exits to close positions. However, we may be witnessing a special situation these days as open interest has increased not only because of the speculators but also because of the bona fide hedging activity of producers locking in prices to survive in the future.
I believe that the trend in term structure in the crude oil market suggests that $50 should hold any speculative liquidation as the hedge selling should also stop below that level. Perhaps the most bullish factor for the energy commodity right now is the prospects for increasing demand from a construction boom and increasing U.S. GDP. Keep your eyes on term structure in oil, if the tightening trend continues it could mean that oil will make yet another higher high and $60 per barrel could be in the cards.
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