Like us, Reuters’ Robert Campbell has been pondering the paradox of backwardation in an oil market that appears to be plentifully supplied.
We missed his article when it originally came out last week, but think it’s worth taking a late look — especially since it complements our abundance series so well, and supports our views on artificial scarcity in commodity markets.
So here’s the paradox as he identifies it:
VIENNA, June 14 (Reuters) – How can oil fall 25 percent in a matter of months when the principal futures market has signaled all along a situation of dearth, not plenty? Or put another way, why have buyers of oil this year been paying a premium for prompt delivery when supply has far outstripped demand? Front-month Brent crude futures have traded at a premium to contracts for delivery two and three months later every single day but one this year.
This market structure, known as backwardation, is generally interpreted as a bullish signal of tight supply. When near month prices are higher than longer-dated prices, holders of inventory have an incentive to sell stocks into the market.
In other words, the market is signaling that it needs to draw down inventory to meet prompt demand.
But the oil market has been building stocks all year.
This is the paradox. How did the futures curve retain this shape when the global oil market was oversupplied relative to prompt demand?
Why was the futures market signaling to holders of inventory to sell stocks at precisely the moment when they were building stocks?
Contradictions FT Alphaville has been pondering too.
Indeed, this is what we wrote in December with respect to backwardation’s weird return:
But now, things are once again returning to the ‘normal’ state of backwardation — a move which has been interpreted by the market as a return to tight fundamentals. But what if – as Goldman Sachs suggested back in September- this has more to do with a change in the preferences of passive buyers?
From about April 2011 both Brent and WTI prices have, after all, reached a stalling point … spot prices have failed to rise at their previous pace. With no spot price returns — the only thing which previously compensated passive buyers for their curve-related ‘negative yields’, it’s suddenly become hugely expensive and unattractive to sit outright and passively in oil.
Accompanied by the following point, that we feel is worth reiterating:
The general scarcity of commodities (and a propensity for illiquidity in the underlying) means commodity curves usually reflect a convenience yield — a situation where holding the underlying good or security makes more sense than owning the derivative instrument, and can be more profitable.
So how does one reconcile bulging inventory with a backwardated curve?
As we’ve argued, one logical explanation is that artificial scarcity is being applied to the market. This could easily be achieved by the accumulation of dark inventory on the supply side or through stocks showing up in inventory data as “available for purchase” when otherwise encumbered.
If consistently implemented, such antics would eventually lead to major capacity shutdowns in refining, because input prices would be too high relative to end-product demand to ensure profitable margin.
Under this scenario, it would also make sense that demand destruction in the developed world would have a diminishing impact on underlying crude prices… a fact which could easily be explained away (by those propagating the myth of artificial scarcity) by emerging markets holding more sway over crude prices than a region that represents 46.4 per cent of overall consumption:
And, indeed, all of these trends have been emerging.
But let’s consider what backwardation means in a world where inventories are hypothetically accumulated on purpose just to create a perception of artificial scarcity so that prices can be supported without production being curtailed.
It’s very possible that a backwardated curve under this scenario begins to represent something entirely different to what it usually would. We’re talking about a fear of future abundance and the expectation of lower prices over time, rather than concerns about current scarcity and expectations that spot rises will rise imminently.
After all, as Campbell notes:
What we are seeing is the oil market equivalent of a violation of the fundamental laws of physics. This is something that should not occur and which demands an explanation.
We believe artificial scarcity may be the only plausible explanation for why such a violation is possible.
Campbell goes on to provide some logical locations for our “encumbered” inventory as well. For example note the rise in strategic stocks we’ve seen over the last few years:
With the flare-up of tensions between Iran and the West at the start of the year, and the unexpected escalation of sanctions against Tehran, Asian strategic buyers almost certainly felt compelled to add to emergency stockpiles.
Strategic stocks differ from commercial inventories in that they are generally held regardless of economic conditions. In other words, there is no need to hedge the position. No selling of futures by the inventory holders to hedge, no reflection of the stock build in the futures curve?
Though as he rightly acknowledges this doesn’t explain the phenomenon entirely:
Perhaps that’s it, but somehow that explanation does not seem complete. It is not the case that all of the stock build has gone to strategic buyers. There has been a marked increase in commercial inventories too. Certainly in the developed world there has been no major accumulation of strategic stocks.
We, for one, think there’s also a large role being played by the collaterilisation and financialisation of oil inventory by means of commodity repos and other financial structures, since these dynamics prevent supplies from being priced through public markets.
But Campbell also acknowledges the ‘tail-wagging-the-dog’ effect that’s potentially being created by the much tighter (but more opaque) Brent market in its own right.
As he concludes:
But perhaps we are now in a situation similar to a dog chasing its own tail. Bullish oil analysts see the market in backwardation, assess global oil supplies as tight and financial players jump into the spread trade, sustaining and amplifying the backwardation.
Physical traders are unable to take advantage of the arbitrage opportunity due to the structural flaws in the Brent market so the backwardation persists.
The distorted structure of the Brent curve reinforces perceptions of tight supply, which in turn drives the flat price of oil higher. If the above theories are true, then serious questions need to be asked about the oil market. Is it really a good idea to base trade on such a narrow basis as Brent? Is it really a good idea to interpret the structure of the Brent market as a proxy for the global oil market? At the very least oil traders should learn lessons from this year. Backwardation is not always a sign of an under supplied market.
The “perception of scarcity” point perhaps being the most important one to be made, we think.
Beyond scarcity – FT Alphaville
The Fed’s oil easing – FT Alphaville
The curious case of ‘abnormal’ backwardation – FT Alphaville
Explaining backwardation – FT Alphaville
Dark inventory, a volatility shock absorber – FT Alphaville