A heads up — This is a three-part series attempting to explain the current backwardation in the market. We will make three arguments: 1) That contango trades helped to create fake demand in 2009/2010 2) that index funds replaced Saudi Arabia as key swing players, 3) that the Brent-WTI deviation can be explained by the current super-backwardation.

Remember super-contango?

Well oil markets have now been struck by the exact opposite situation.

Behold super-backwardation — a scenario which can best be described as unconventionally strong demand for spot physical oil, at least when compared to the futures market (usually the domain of financial investors).

Conventionally, this sort of backwardation would result in extensive stock drawdowns, eliminating supply buffers form the market, seeing prices ascend.

The curious thing is that while we are seeing the stock drawdowns, there’s yet to be any corresponding bullish moves in prices. It is, as we have noted before, a bit of a mystery.

Wednesday was a good example of the anomaly. US crude inventories declined by much more than the market expected, and yet both Brent and WTI prices failed to rally in any meaningful way:

So we find ourselves in a situation where across the board — despite no change to spot prices — all physical producers are opting to sell inventory. Financial investors on the other hand — who would actually collect a roll yield from holding future positions on the curve are opting to sell out, only adding to the backwardation (at least according to Goldman Sachs).

Indeed as Robert Campbell at Reuters noted the strange situation on the day:

U.S. oil companies are dumping inventory as fast as they can, likely guided by the sharp backwardation in the Brent futures curve that points to much cheaper prices just a few months down the road.

The back end of the Brent curve has fallen heavily over the last month, reflecting as much the market’s perception that supply tightness in Europe will be short-lived as jitters over the global economy.

Meanwhile, at the front of the curve, tight supplies stemming from the loss of Libyan output and a summer of North Sea disruptions continue to play a leading role. As Chart 1 shows, Brent crude for delivery 12 months out has moved to its deepest-ever discount to the front month, surpassing the levels seen in 2007 and 2008 when outright front-month prices hit records.

But Libyan supply is set to be resolved shortly.

Thus, it’s not even clear that Libya is behind the current spell of super backwardation, at least not with respect to static (or even falling) spot prices in the face of large inventory drawdowns.

There is the theory that the destocking itself is suppressing spot prices, by adding extra supply into the immediate physical supply/demand balance. But in that case, it seems that  the destocking may be the result of the shape of the curve, rather than the cause of it.

So what is happening?

Well consider, first, that until futures positions transform into physical deliveries, the physical market possibly operates under completely different supply and demand fundamentals to those of the financial market.

In that scenario, anyone who has the ability to bridge the imbalances between these two supply and demand zones has the ability to profit from working opposing views against each other.

For example, if there is more demand from financial investors than there is from physical investors on convergence day, you should end up with a scenario in which financial investors are penalised with financial losses if they opt not to take delivery of supply –  a move which may make them reconsider their view. However, in the event they don’t change their view, those funds continue to be reinevested into subsequent futures contracts. If there aren’t enough physical hedgers willing to sell futures as there are financial investors willing to buy them, an imbalance drives futures prices on the curve higher — a fact which results in a contango structure.

In this structure, it makes sense for physical producers with more supply (than current market dynamics require) to sell the inventory forward at a premium to the current market price — especially if their view is bearish. The relationship is symbiotic, since (if there is still too much supply expected next month) the physical hedging flow matches the excess demand from the financial investor base and hopefully brings the immediate spot market back into balance. Providing that the physical players are compensated for storage costs of withholding that additional oil from the market, they are indifferent on whether they sell it today or sell it forward.

Of course, if there are yet more financial investors on the curve than physical sellers willing to hedge, financial investors will need to compensate physical traders above and beyond storage costs to convince them to withhold their oil from the market. This is how a super-contango comes about.

The result is a money making opportunity (or super contango) for anyone who has supply and is willing to withhold it from the market. It’s hoarding, but it’s good hoarding, since ultimately it should support an imbalanced market which was suffering from too much supply. You can also think of it as stealing demand from the future to deal with immediate imbalances today. Or “fake physical demand” fuelled by investors willingness to provide compensation and financing to today’s physical market which is suffering from oversupply. They don’t mind — they think they will profit from those positions in the long run.

Ultimately the act of hoarding should see prices rise above and beyond the price of future, which would incentivise producers to release the stocks back into the market rather than to continue to sell forward.

The hoarding simply eases the volatility associated with market imbalances and acts as a buffer. It’s why markets like that for electricity are so much more volatile, since storing power is not as easy. Producers have to adapt quickly to meet market imbalances instead.

In the next post of this three part series, we will argue that index funds, prompted by access to cheap financing and a willingness to overpay for crude futures, effectively became the new swing players in the market . By doing so they created fake demand and supported prices at levels that benefited the entire industry. Including Opec.

Related links:
Just when it makes sense to sit in oil futures… - FT Alphaville
Brent’s got its problems too – FT Alphaville
‘WTI about as useful as a chocolate oven-glove’ – FT Alphaville
Bye, bye Cushing syndrome (possibly) – FT Alphaville

This entry was posted by Izabella Kaminska on Thursday, October 20th, 2011 at 9:56 and is filed under Capital markets, Commodities. Tagged with backwardation, contango, futures, oil. Edit this entry.