Forward curves in energy often lead to confusion. It’s very tempting to see them as a forecast of price, however, as FT Alphaville and Reuters columnist John Kemp (former Sempra analyst) have argued frequently — it’s not as easy as that.
Jumping aboard the “you don’t understand the forward curve” bandwagon Wednesday morning are Dennis Gartman of the Gartman Letter and Stephen Schork of the Schork Report. They specifically take issue with a certain article by Bloomberg:
Jan. 5 (Bloomberg) — The steepest plunge in crude prices on record may be setting up oil investors for a rally this year, if history is any guide. The so-called forward curve of futures contracts traded on the New York Mercantile Exchange suggests oil will rise 28 percent to $60.10 a barrel by December. The curve looks almost the same as 10 years ago, after Russia’s default and the collapse of the Long-Term Capital Management LP hedge fund raised concerns that a global economic slowdown would reduce energy demand. Crude prices fell 25 percent in the final quarter of 1998, the steepest drop in seven years.
But as Schork explains the current contango is not a sign of future demand for crude oil rather, a clear indication of just how bearish the present situation is. To draw a comparison between today and 1999 is also misleading, he says:
Fair enough, crude oil prices dropped by 55 percent in the fourth quarter of 2008. But, then again, in 1998 prices were falling from $16 to $12 in a red-hot (remember those dot.com valuations) economy. Today, crude prices plunged from a historic bubble that topped near $150 in the midst of the first true global recession since the Great Depression. For example, in the fourth quarter 1998 when crude oil was dropping to $12, U.S. economic growth was 6.2 percent. Last quarter, when crude oil was dropping to $45, the U.S. economy was probably contracting by around 0.5 percent.
In hindsight, Russia’s default nor LTCM’s implosion (which btw, was a fraction of the recent string of implosions, from Amaranth to Lehman) never sidelined the U.S. economy. So, it is true that the 1999 NYMEX curve is similar to the 2009, and if you bought crude oil in 1999 based on the contango alone, then you would have done very well. On the other hand, the 1998 NYMEX curve was similar to the 1999 and 2009 curves. If you had bought in 1998 on the theory that a contango is a signal that the spot price would rise in the future, then you would have done very poorly, i.e. the February 1998 expired at $17.43, while the December 1998 contract finished at $12.14. So, which is it… 1998 or 1999? We will venture that we are a heck of a lot closer to 1998 than 1999.
Gartman also agrees that Bloomberg’s assumption is utterly wrong.
More interestingly, however, Gartman reminds us that Bloomberg is not alone in its incorrect assumption — Mr. Ben Bernanke has apparently got it wrong too:
Bernanke himself fell into this same trap two years ago when crude was in a very steep backwardation, saying that the crude futures were predicting lower prices ahead and that that was a reason for the Fed to err upon the side of easier monetary policies. Instead the backwardation actually agued that crude inventories were tight and that prices were about to rise… materially… which they did.
So there you go, it can even happen to someone who really should know better.
Meanwhile, the differential between WTI and Brent continues to widen as the contango in WTI intensifies and Brent’s peters out, with front-month WTI trading at $48.37 per barrel and Brent as high as $53.55 Wednesday. This has much to do with commodity index rollovers and rising stocks in Cushing, all of which are impacting WTI pricing — breaking the contract’s connection to real supply and demand fundamentals. As Petromatrix explains:
We warned about weakness to come Tuesday on the WTI front spread as the USO WTI ETF had to roll in a single day a record long position from Feb to Mar and indeed the Feb/Mar WTI contango widened by about 60 cents/bbl. The WTI ETF also closed rather than rolled 7′900 Feb contracts which added further weakness on the front month. The record WTI ETF roll has taken some spread liquidity away for the roll of the S&P GSCI that starts tomorrow and this could make for an increasing two-tiered market in days to come where Feb WTI disconnects further from the rest of the world. The disconnect of the front WTI contract translates also in a strong widening of the unusual Brent premium to WTI and with OPEC apparently complying better than expected with their decided cuts, it will not take long before US based crude oil start to price a workable arbitrage to Asia.
Related links:
It’s all about Cushing - FT Alphaville
Why the forward curve is NOT a forecast - FT Alphaville Long Room
Is it a bird? No it’s a super contango - FT Alphaville
