Boiling oil into backwardation

As can be seen in the chart below from Stephen Schork of the Schork Report on Tuesday, the contango in the WTI Nymex crude market has weakened over the last few months quite substantially:

Contango weakening - Schork Report

A weakening contango, of course, is traditionally seen as a bullish sign for the crude market. If only that were so this time round, however…

In fact, all indicators suggest the contango may only be weakening because traders are seeing sense in processing crude into products like gasoline and distillates, where there’s still a significant payoff for storing volumes over time.

As Schork explains:

The historical implication is that an incentive to refine crude will lead to a temporary increase in product stocks, whose prices will fall accordingly as equilibrium is reached.

However, there are two differences between now and 2006. Firstly, as mentioned in reports passim, consumer price sensitivity to gasoline prices has weakened, so lower prices do not automatically lead to a higher uptake of products. For instance, the correlation between gasoline production and stocks for 2009 is 0.243, up from 0.158 over the 2003-07 timestep. That implies that the gasoline produced is going straight in to storage and not in to the market. Secondly, as of last week’s DOE report, the year on year gasoline surplus was 12.1% while distillate fuels rose to their highest level since January 1983.

So the destocking in crude may not be connected to any fundamental pickup in demand at all. As Schork says, the product is simply going straight into storage.

In which case, investors interpreting the flattening of the contango as a bullish marker should probably beware.

Related links:
Betting on Brent
– FT Alphaville
Demand is in the toilet
- FT Alphaville
Distillate hangover
– FT Alphaville

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