In recent weeks, the futures curve for West Texas Intermediate (NYSE:WTI) crude oil, traded on the New York Mercantile Exchange (Nymex), has seen some significant steepening as near term prospects for the US oil market diverge away from the broader outlook across crude oil markets. At the same time, the US crude benchmark is no longer showing the traditional premium over the European benchmark Brent crude, and has in fact reversed, and extended Brent’s comparative outperformance (or more accurately WTI’s underperformance) over the same period. Considering these things, it is implicit that some near term bearish factors have been hitting the market in recent weeks, while at the same time the longer term and more fundamental outlook for crude oil going forward, has at least remained stable and perhaps even firmed up a little.
The ‘normal’ or ‘fallback’ position for any commodity futures curve is a contango, that is to say the price of each futures contract get subsequently higher as you move further outward along the curve. The opposite to this, which relatively infrequently happens and tends to be on one or two individual contracts, rather than a systematic shift across the curve, is backwardation, where a future price goes below the price of contract at the shorter end of the curve. This state of contango comes about form the very nature of derivatives contracts and the commodity markets. It is a common misconception that a futures price somehow represents a predication of what the commodity’s price will be at a given point in the future. Although, as we will soon see, there is undoubtedly an aspect of expectations from the market as to where the futures price will be compared to current price (e.g. longer term outlook better than near term, means long end of curve will outperform short end), futures contracts should in a perfect market represent the current price of the commodity, plus the cost of storing that commodity for the period until that futures contract expires. This comes about through the potential arbitrage opportunities that any premium over this level offers.
If we demonstrate this with an example: if the current price of crude oil is $70/bbl, and the twelve month future is trading at $80/bbl, then one could purchase the front crude contract and sell the twelve month future contract at this point in time, immediately locking in $10/bbl profit. There is a cost of storing a physical commodity over a time period however, so for crude this may be warehouse or tanker storage, rents etc. If we assume that this is say $3/bbl over twelve months, then in the above example the profit would actually be $7/bbl.
With this arbitrage opportunity in place, the market as a whole would buy more front month contracts, driving up the price, and sell more of the twelve month contract, pressuring prices. As with the classic Adam Smith example of ‘invisible hands’, these two prices would converge as long as it is profitable. Eventually the future price will only represent the current price, plus this $3/bbl cost of storing crude for twelve months as this in effect means the marginal revenue will equate to the marginal cost, and cetris paribus, no further demand or supply will come through in either contract.
Unlike the calendar spread, the traditional difference in price between the WTI Nymex crude benchmark and the European Brent Crude benchmark, traded primarily on the Intercontinental Exchange (NYSE:ICE), comes about because of the fundamental differences between the two crude oil products. Although both are classed as the higher quality ‘light sweet crude’ (high gravity, lower viscosity, low sulfur, primarily used in high end products such as gasoline), there are some mild difference between the two that result in WTI contracts, generally showing a premium of around a few dollars over the equivalent Brent contract.
Brent crude, unlike WTI, is actually a blend of light sweet crudes from fifteen different oil fields located across the North Sea, and because of this actually has a slightly higher sulfur content and a slightly lower API gravity, i.e. Although it is light sweet, it is not quite as light or as sweet as WTI (API Gravity 38.3 degrees versus 39.6 degrees for WTI, sulfur 0.37% versus 0.24% for WTI), and as such, sees slightly less demand and so is cheaper (generally speaking) than WTI.
This is not currently the case however, with the front Brent contract trading around $3/bbl higher than the WTI contract. Although one could consider this as an indication of a fundamental market shift in conditions surrounding the two benchmark types, if we take it in context of the widening contango in the WTI curve itself, it would seem to indicate more specific pressure at the front of the WTI curve. Indeed, if we compare the June 2011 (Jun11) Brent contract to the Jun11 WTI future, the Brent contract only trades around 30 cents higher than the WTI, in effect showing us that in the longer term, the fundamentals between the two benchmarks are expected to fall back to the norm.
So this brings about the question, what is currently bearish for the front of the US crude curve, while having a lesser impact on the broader crude oil market?
The primary reason for this over the past few weeks has been the continuing turmoil surrounding the Greek debt crisis, the potential for other European peripheral countries to go down the same path, and all the subsequent risk aversion and currency moves coming off the back of it. This has been impacting the front WTI contract in two predominant ways; firstly, the highly liquid and predominantly paper traded, WTI front contract has over the past year or so been showing a high correlation with the equity markets, traders in effect taking stock indices as an indicator of global recovery and potential future crude oil demand.
The Greek crisis has caused a widespread sell off in global stock markets amid fears that banks across the world may have exposure to the country’s sovereign debt, which Greece has the potential to default on. This increased risk aversion across the markets has caused a flight to safety for traders, with those holding speculative positions at the short end of the WTI Nymex curve, quickly closing positions. Coupled with the correlation between the front WTI contract and stock indices (The current Jun10 contract and the S&P 500 stock index show a correlation of 79%), the front of the curve has been seeing the brunt of the selling pressure.
Secondly, the Greek debt problems have naturally caused the euro to devalue against the US dollar. As Greece (and other periphery countries) looks set to have less foreign investment, lower GDP growth etc, the euro has been steadily losing ground during this crisis. A weaker euro has made the comparative cost of buying WTI contracts, priced in US dollars, more and more expensive for those traders based in Europe. This has caused demand to slacken in the near term and in turn, placed pressure at the front of the WTI curve.
While the further dated contracts have been following a similar price performance, it has been to a much lesser extent than the more immediate impact on the WTI Nymex Jun10 contract. Similarly, although Brent crude is also priced in US dollars, it is primarily traded within Europe and in Asia, and so the falling euro dollar has had far less impact (the generally weaker euro against Asian currencies is having some impact, but again to a lesser extent than for the US benchmark).
This divergence between near term and longer run fundamentals for crude oil has been the key weight in recent weeks as the Greek debt crisis continues to dominate news flow.
This isn’t to say there are not a myriad of other factors to consider, both for calendar spreads and the WTI – Brent spread. But the Greek crisis and subsequent moves in the stock markets and currencies markets have been the key driver behind the widening spread and the steepening of the WTI futures curve since the news surrounding Greece began to come to the forefront.
Whether or not this becomes a more systematic shift for crude oil products remains to be seen, however it is certain that until fears surrounding Greece and European peripheries begin to wane, the short end of the WTI Nymex crude curve has at least one hurdle to overcome on its road to recovery.
Disclosure: The author holds no positions in the company