It was quite a day on Monday for the WTI US oil benchmark. The structure of the futures curve finally flipped into a subtle backwardation, seeing the contract join Brent in a formation which sees front month futures trade more expensive to those further out.
The last time WTI was seen displaying a backwardated structure was in October 2008.
This for example was the move between the front-month and second-month contracts in WTI (see orange):
And it was even more pronounced between the second month and the third:
Meanwhile, the backwardation over in Brent eased as follows (orange line):
And again the shift was more pronounced between the second and third month:
The WTI-Brent spread closed in to its narrowest level since July/August 2011 as a result:
Though, to be fair, nobody really understands what prompted the changes.
One theory, as we have argued before, is that an exit of passive money from WTI and into Brent could begin to pull the WTI contract into backwardation, while easing the very same state in Brent.
It’s possible, furthermore, that it was a lack of passive money in Brent (compared to WTI) which helped flip the Brent contract into backwardation in the first place. The industry’s desire to exploit that backwardation, meanwhile, may have prompted the sudden and mass defection of industry players from the WTI benchmark market and into the Brent contract early this year.
Or as we put it last week:
Ultimately, if fund and financial flows flood the market in a similar way they flooded the WTI market, the Brent curve will revert to contango — allowing the industry to make money via their backwardation trades.
So, if passive money is what supports contango, an exit of passive money logically supports the opposite, a reversion to backwardation and industry destocking.
Robert Cook at KBC explained the backwardation incentives nicely on Monday:
The slow pace of the return of Libyan oil to the market is another reason that supply has been tight, and this has resulted in a steep backwardation on the North Sea grade, where prompt oil for physical delivery sells at a premium to the futures market. Because prompt oil is more expensive, this tends to make buying it and storing it more expensive than buying it on the futures market for delivery at a later date.
Meanwhile, the reason a fresh flip from one structure to the next is so exciting for the industry is because it allows for the immediate application of so-called backwardation trades.
As Olivier Jakob at Petromatrix noted on Tuesday these are often automated, and if anything encourage an immediate reversal (if the view is that the backwardation won’t last) or exaggerate the trend (if the view is that the backwardation will only intensify).
In this case it was the latter:
The risk was to see the backwardation/contango systematic trading models come back to WTI on the backwardation signal and it did not take long. As soon as WTI hit the backwardation on the Dec/Jan spread, WTI started to fly away with the automated flows coming for the backwardation; and reducing the Brent premium to WTI in the process. We have seen more backwardation/contango systematic funds develop over the last two years but we were still impressed with the flows triggered by the WTI backwardation. Volume in WTI surged to the highest level since the Libyan uprising in February, while volume in Brent was barely higher than the low levels of Friday
If the trend continues, a further intensification of the WTI backwardation alongside an easing of Brent’s backwardation should be expected — as can a continued narrowing of the WTI-Brent spread.
Though there are some caveats. The first, we would argue, is if not enough passive money flows over to Brent. In that case, the WTI-Brent spread may still close in but both markets will remain tight in response to it making little economic sense to buy and store oil.
The second, if the market responds to the new structure by forcing one last shake-out of short positions in Brent. Though given the intensity of Monday’s WTI move, it may be too late for that in the Brent market.
Indeed, what recently became a traditional monthly shake-out of short positions in Brent may have headed over to WTI this time — possibly because there wasn’t enough passive money rolling over to satisfy those shorts accustomed to taking advantage of expiry rolls (since the elephant-like funds sell the front months and buy the next months down). If you were positioned to make money on exactly this guaranteed routine, a lack of passive rolling could have caught you out. This is especially so, if you were simultaneously positioned long in the following contract and not enough money came into to justify selling at a premium.
The November WTI contract expired on Oct 20, which could suggest some industry repositioning is happening now.
If this really is what’s happening, then the WTI backwardation — which would ordinarily signal a tight market in the face of strong demand — should be taken with a pinch of salt. After all, as Stephen Schork points out on Monday, the bearish fundamentals simply haven’t changed enough to justify the flip.
As he noted on Tuesday (our emphasis):
Bottom line, spot oil futures on the ICE rose by 1.7% yesterday, whereas the corresponding contract on the NYMEX jumped by 4.4%. As such, the spread between the ICE BRENT and NYMEX WTI markets converged by $1.95/b or 212 bps to -$20.18/b in approximately 18½ hours of trading. Given that fundamentals simply cannot change that fast, we are left to assume someone(s) is getting the squeeze put on them.
Either way, a little fund flow analysis could be the key to determining what’s really happening.
Related links:
The curious case of super-backwardation – FT Alphaville
Just when it makes sense to sit in oil futures… - FT Alphaville
Are index funds the new swing producers? - FT Alphaville
The WTI-Brent anomaly - FT Alphaville