The oil market is slipping into a situation called contango. And while this may sound vaguely dance-inducing, history shows that the turnaround is not a positive sign for crude oil prices.
Contango is a trading language used to describe when the prices of nearby futures contracts will fluctuate — right now, say December West Texas Intermediate crude CLZ23, +0.33% — versus January WTI CLF24, +0.29% or other contracts like Trade at a discount to deferred futures contracts. Line.
What is contango?
According to Dictionary.com, the term is believed to have originated on the London Stock Exchange in the 19th century, describing a fee paid by a buyer of securities to a seller for the privilege of deferring payment.
Admittedly, oil markets – and other futures markets – are often controversial reflecting the cost of storage and other factors. But the exit condition from contango known as backwardation – when nearby contracts trade at a premium to deferred contracts – is often seen as bullish, indicating a tight physical market in which the last Users are struggling to secure supplies.
The oil market has been in the red for most of this year, a move that came ahead of a summer rally that was originally linked to a tightening of supply as Saudi Arabia in July cut production by more than 100,000 oil per day by fellow OPEC+ members. A production cut of 1 million barrels was implemented.
Robert Yoger, executive director of energy futures at Mizuho Securities, said the WTI price curve traded in contango earlier this month for the first time since July 20, three weeks after Saudi Arabia’s additional 1-mbd cut took effect.
WTI, as measured by the spread between the first-month and second-month contracts, closed in contango again on Wednesday and was on track to do so again on Thursday. According to Dow Jones Markets data (see chart below), WTI has not seen a sustained period of contango since July.
Much of the market’s previous backwardation has been erased as oil futures retreated from 2023 highs reached in late September, with the market increasingly optimistic about a surplus of crude in the first half of next year.
soft body?
“We have a weak oil market, a soft physical market,” Vikas Dwivedi, global energy strategist at Macquarie, said in an interview earlier this week.
Crude oil reserves in the US have increased this month and Macquarie expects this to continue till January. As a result, the era of high backwardness has ended or disappeared.
Dwivedi said Macquarie not only expected a move into contango, but he expected some WTI contracts “could go into substantial contango along the curve.”
“This scenario is very important to our thinking that oversupply is real,” he said. “It does not require a hard landing or real demand challenges from a global recession.”
trouble with the Curve
The bearish trend towards contango may seem counterintuitive. After all, wouldn’t futures pointing to higher prices in the future indicate that oil will rise in the future? It doesn’t necessarily work that way.
Investors pay attention to the shape of the so-called futures curve, which is a line representing prices in futures contracts. Pimco’s Nicholas Johnson and Andrew DeWitt noted in a 2017 paper that the shape of the futures curve has historically been one of the best predictors of future returns.
For example, he cited that the subsequent 4- and 12-week returns for long positions in oil futures during the downturn were 1.3% and 2.9%, respectively. By comparison, long positions saw returns of negative-1.7% and negative-3.8% for the same periods during contango.
According to Macquarie, the move into contango was driven by rising sweet crude oil production in the US, the North Sea and Brazil, as well as growing signs of non-compliance with OPEC+ production cuts.
Crude oil could see a near-term rally, with a possible year-end rally due to portfolio management concerns, with futures becoming oversold after falling to mid-July levels, Dwivedi said. .
When contango becomes a ‘big problem’
Meanwhile, a deeper move into contango, which has not yet occurred, could be self-reinforcing.
Contango becomes a “big problem” when the spread becomes larger than the cost of carry, which is typically around 50 cents a barrel, Yoger noted in a Wednesday note. Carrying costs include storage, transportation, interest and other charges.
He wrote, “Once the contango spread reaches a level greater than the cost of carry, large players who can make and take delivery can buy in front of the curve and sell for a month and automatically You can book profits accordingly.” “As those barrels stack up in storage, they put pressure on the spot, leading to recession.”
Crude still has a long way to go before it reaches that point, “but deep contango in any commodity becomes a tough place to be.” [speculator] To make money,” Yawger said.
Source: www.marketwatch.com
