Possible Bullish OPEC Oil Play On Backwardation

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWT
by: Robert Boslego

Summary

OPEC has cut back to reduce OECD stocks.

It expects higher prices and futures market backwardation as a result.

The futures market is signaling it's going to take more than a year.

It could shock the market to get nearby prices higher now.

But that strategy risks a policy retaliation.

OPEC's expressed goal with its cutbacks is to reduce OECD oil inventories to their 5-year average. Saudi Energy Minister Khalid Al-Falih suggested that global inventories may sink to their five-year average by June, rendering a continuation of the cuts unnecessary beyond June.

According to data by the Energy Department, OECD stocks stood at 3.101 billion at the end of December. This figure was 331 million barrels more than the 5-year average (orange line).

Thus far in 2017, U.S. oil inventories rose by 26 million barrels. Updates for January OECD levels will be available in 4 days. I believe they will show that OECD stocks have been risen, not fallen. OPEC will say that transit times have delayed the effects of the cuts on inventories.

I have written that OPEC's strategy of limiting production to achieve desired prices is less efficient and effective than a more direct strategy of increasing prices slowly on a schedule, and allowing market demand to dictate production levels.

OPEC's apparent goal of its cutbacks is to push inventories lower, which should increase oil prices levels. It may also result in futures market backwardation.

For non-oil traders, contango is a futures price market structure in which future prices are higher than the nearby contract. A backwardated market is one in which future prices are lower than the nearby contract.

Ever since the November OPEC meeting, crude futures prices have remained in a contango market structure, with the nearby price lower than futures prices. Such a structure is favorable for crude producers who can hedge (sell) at higher future prices, and adverse to OPEC producers, who sell at discounted current prices. It also creates an incentive for oil companies to store oil to repeat the benefit of higher prices later, which can be locked-in though hedging.

After the OPEC agreement was made, I noticed that the market structure had changed. Crude futures in December 2017 were high than contract prices in 2018. For me that signaled a market expectation of supply-demand rebalancing because contango generally occurs in oversupplied markets, as we have been experiencing.

Most recently, the market has shifted the start of backwardation to begin in May 2018. In other words, it now expects the supply-demand rebalance to take an additional five months.

If OPEC could force the market somehow to flip to backwardation, it achieves three goals: a premium of spot prices to futures prices, a disincentive for oil companies to build (or hold) high inventories for profit, and a discouragement of crude producers to hedge which could reduce producers plans to ramp-up future production.

Is there anything OPEC can do to achieve that goal more quickly than waiting for supply and demand to rebalance through market mechanisms beyond the current cuts?

A backwardated market is reflecting an expectation that futures prices will not be as high as current prices. Last May 2016, the contango market structure dissipated (but did not completely disappear) due to the unexpected outages around the world, including the wildfires in Canada.

Conclusions

And so some "shock" announcement by Saudi Arabia that it would reduce its output by another 2 million barrels per day temporarily might cause nearby futures prices to surge above deferred contract prices. A flip to backwardation would lead to oil company de-stocking more swiftly, as well as crude producers reducing (buying) their hedge positions.

The strategy would face the risk of retaliation by the Trump Administration. The U.S. could accelerate the drawdown of the Strategic Petroleum Reserve, for example. But if the price effect were limited ($10/b), that risk might be small. In fact, the Saudis could signal that it will temper its cutback when prices reach $65/b.

OPEC has taken the position that it is not attempting to set prices. But by doing so, it is not utilizing the most powerful weapon it has, which is to provide a price signal. This can always be revised if it finds the production implications do not provide the price-production combination it wants.

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.