Oil Market Marches on Toward Backwardation
Oil traders are increasingly convinced the market will rebalance over the next year with a major drawdown in crude and products stocks.
Conviction about market rebalancing is showing in a big rise in the calendar spreads for West Texas Intermediate (WTI) and especially Brent crude in the last two months.
Calendar spreads, which measure price differences between any pair of contracts with different delivery dates, are closely tied to changes in the supply-demand balance.
Calendar spreads are conventionally expressed as the price of a near-dated futures contract (such as October 2017) minus the price for a contract maturing later (such as March 2018).
When the oil market is oversupplied, and crude stocks are high and rising, calendar spreads tend to be negative, a state known as contango (near-dated contracts trade at a discount).
When the market is undersupplied, and stocks are low and falling, calendar spreads tend to be positive, a state known as backwardation (near-dated contracts trade at a premium).
The relationship between spreads and stocks was identified by the economist Holbrook Working in the 1930s in relation to grain futures trading ("Price relations between July and September wheat futures at Chicago since 1885", Working, 1933).
But the same relationship between spreads, inventories and the supply-demand balance has been evident in the oil market since the 1990s.
As the oil market has cycled between periods of undersupply and oversupply, the calendar spreads have cycled between backwardation and contango.
Brent spreads slumped into contango in the second half of 2014 as the oil market became oversupplied, and have stayed there for the last three years as the market struggled to digest excess stocks.
But as the market transitions from oversupply in 2014/15 towards a period of undersupply in 2017/18, spreads have tightened.
The contango in WTI and Brent futures has been narrowing progressively since early 2016, which is consistent with a market starting to draw down stocks as a result of lower supply and faster demand growth.
In the later stages of rebalancing, spreads are likely to move into backwardation to increase supply, moderate demand and stabilise inventories.
Something like this appears to be happening with an unusually large seasonal reduction in crude stocks in the United States.
Saudi Arabia has pledged to reduce its exports in August and September, and is curbing shipments to the United States, to accelerate the rebalancing.
In response, the contango in WTI has narrowed sharply in recent days, and Brent futures are now trading in a small backwardation for the nearest-to-deliver contracts.
As the oil market continues to rebalance, WTI and Brent are likely to move more deeply into backwardation.
Because of their close link to stock levels, calendar spreads are popular with physical oil traders and hedge funds as a way to speculate on changes in the supply-demand balance.
As rebalancing unfolds, physical traders and hedge funds normally take a long position in the calendar spread (buying near-dated futures contracts and selling others maturing later).
In this way, speculators tend to accelerate the shift from contango towards backwardation, but because there is an anticipatory element, the adjustment can also overshoot and then correct.
In April/May 2016 and January/February 2017, the spreads tightened significantly, then subsequently eased, in a possible indication of overshooting.
Something similar may be happening at present, with the spreads for Brent and WTI narrowing sharply in the last four weeks.
In the short term, calendar spreads can also be distorted if traders attempt to squeeze the market by buying up all the available physical cargoes.
But the underlying trajectory from contango towards backwardation has been fairly consistent over the last two years.
The gradual march towards backwardation will continue over the next year unless the rebalancing is thrown off course.
(By John Kemp)