Download Shapeshifters: Yearning for Backwardation

Shapeshifters: Yearning for Backwardation
By Max Schlubach
When crude oil traders speak of the forward curve or “term structure” of the futures market, they reference
the line chart that depicts the current cash (spot) price of crude oil alongside the prices for delivery of crude
at future points in time. If the line is sloping upward, it means spot prices are trading at a discount to future
prices; this term structure is called contango or – more colloquially – the market is in “carry.”1 Conversely, if
the futures curve line is sloping downward, it means the current price is trading at a premium to future pricing;
this term structure is called backwardation. The shape of the forward curve in a deep, liquid futures market –
like crude oil – can be interpreted many ways. The most active commercial participants in the crude oil futures
market are exploration and production (E&P) companies, trading companies and refiners that employ futures
to hedge their natural exposure to price risk. Their collective expectations and behavior drives the crude oil
term structure that we explore in this article.
8 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
What does the forward curve tell us about
supply/demand fundamentals?
The slope and trend of a futures market structure means different things depending on whether the market is oversupplied,
in equilibrium or undersupplied. While the market remains in
an oversupplied state,2 the current term structure suggests the
market is betting that OPEC will likely extend its targeted supply
cuts, given that the price for future delivery of crude is currently trading near parity to the cash/spot price for crude. During
the first half of April, futures contracts trading for 2018 delivery backwardated, indicating a collective view that supply will
exceed demand growth – and stocks will build – next year.
Contracts for 2017 delivery remain in contango, reflecting both
the oversupplied cash market and the bet that OPEC will extend
its supply cut through year-end.
is currently oversupplied reduces prices at the front end of the
curve. In addition, since the market tends to expect that E&Ps will
respond to the inventory glut by cutting production, price expectations over the long term tend to creep up. This is first reflected
in increasing prices at the “far end” of the futures curve.
At its most basic level, any single price shown on a forward curve
reflects the market’s view about the balance between supply and
demand at a future point in time. The slope of the graph formed
by plotting those prices reflects anticipations about what will
happen over the course of time – parts of the forward curve can
show contango, while other parts exhibit backwardation. The
causal relationship between supply expectations and the forward
curve slope is foggy, though. There is reflexivity between participants’ behavior and the shape of the term structure: Market
actors must be careful not to mistake a dog wagging its tail for
the opposite.
A prolonged, backwardated
market structure is what
OPEC needs to reach its
objective of reducing global
stocks because carrying
inventory becomes financially
burdensome in a market that
lacks contango.”
When a contango market structure persists in an oversupplied
market, it signals the market is likely struggling to deplete stock
levels. This has been the case since January 2015 and is depicted
in the nearby chart, which maps the Brent term structure against
the prompt month pricing.
$160
-$15
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In an oversupplied market, when market perceptions begin to
shift to the view that oversupply will dissipate (and that nearterm supplies will tighten), crude oil consumers, or refiners – who
are naturally “short” crude oil in that their earnings benefit from
falling crude prices and suffer from rising crude prices – tend to
increase purchasing and hedging activity. This, in turn, drives up
nearby prices and tends to flatten the futures curve. Producers
react to the higher prices by increasing production volumes and
adding supply to the market, which pushes down longer-term
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Brent Prompt Month (LHS)
13
$20
2
$15
$20
1
$10
$40
11
$5
$60
0
$80
9
$0
8
-$5
$100
08
-$10
$120
7
$140
Contango
OPEC Cut
Backwardation
Shapeshifted – Contango to Backwardation
Brent Term Structure (RHS)
Source: Bloomberg and BBH Analysis.
Data as of May 8, 2017.
In the oversupplied crude market that we have faced for the
past several years, forward prices have generally traded at a premium to spot prices – that is, contango. The view that the market
1
2
F or more information about crude oil contango economics, read our October 2015 Commodity Markets
Update article, “The Contango Trade: A Cost of Capital Competition.”
For more information about the global crude oil supply and inventory glut, read our May 2016
Commodity Markets Update article, “Crude Oil and the Four Laws of Gravity.”
Issue 1 2017 9
price expectations and thus flattens the longer-dated end of the
curve. Given that changes in demand and speculative positioning have been minimal, this pattern of increasing supply leading
to lower prices and a steeper curve, followed by periods of inventory drawdown and flatter to backwardated curves, is essentially
what has taken place in crude markets since OPEC announced
its targeted production cut last year.
On November 30, 2016, OPEC announced a member agreement
to restrict production for the first six months of 2017. Its objective
is to reduce global crude oil stockpiles that had built to recordbreaking levels over the preceding five years, swamping the world
in a well-documented supply glut. A prolonged, backwardated
market structure is what OPEC needs to reach its objective of
reducing global stocks because carrying inventory becomes
financially burdensome in a market that lacks contango. Stock
drawdowns typically follow backwardation because owners of
oil inventory are financially punished for storing oil in a backwardated market when they roll hedges – that is, when they close,
or buy back, a close-to-expiry short futures contract at a price
higher than what they can sell a new or replacement short futures
contract for. This market structure provides incentive for inventory
owners to sell. For producers, backwardated markets typically
augur production restraint because a downward-sloping futures
curve indicates that wellhead rates of return will drop due to the
market signaling lower future prices. The crude oil futures market must show backwardation in order for OPEC to meet its
collective objective of a global stock drawdown.
Brent Crude Futures – Term Structure Changes
Brent Crude Price ($/bbl)
$65
$60
$55
$50
$45
Jan-24
Jul-23
Oct-23
Apr-23
Jan-23
Jul-22
Oct-22
Apr-22
Jan-22
Jul-21
Crude Oil, Brent (ICE)
12/15/2016
Oct-21
Apr-21
Jan-21
Jul-20
Oct-20
Apr-20
Jan-20
Jul-19
Crude Oil, Brent (ICE)
11/29/2016
Oct-19
Apr-19
Jan-19
Jul-18
Oct-18
Apr-18
Jan-18
Jul-17
Oct-17
Apr-17
Jan-17
$40
Crude Oil, Brent (ICE)
5/8/2017
Source: Bloomberg and BBH Analysis.
Data as of May 8, 2017.
The long-telegraphed but much-delayed announcement marked
the cartel’s first coordinated output reduction since the 2008
financial crisis. OPEC supplies roughly one-third of the world’s
Lewis Hart and Max Schlubach of the BBH Commodities & Logistics
team visit a crude oil storage facility in West Texas.
daily crude oil requirements and produced around 33.2 million barrels per day during the fourth quarter of 2016. The group intends
to cut output by roughly 1.2 million barrels daily, with a targeted
production cap of 32.5 million barrels each day. Furthermore, certain non-OPEC members agreed to reduce output by an additional
600,000 barrels per day, with Russia making up 300,000 of that
amount. This announcement marked a shift in the psychological tide of the crude market, despite the announced volume cut
amounting to around merely 2% of daily global crude oil supply.
When a term structure flips, it blasts a foghorn that market expectations of future supply have shifted. The nearby chart indicates
that the shape of the curve (the green line) is now effectively flat
to backwardated. The Brent futures contract lost virtually all of its
contango structure the day following OPEC’s announcement – the
blue line was Brent’s term structure the day before the cut, while
the purple line was its term structure the day following. As of this
writing, we are four months into the production cut, and OPEC’s
compliance with it has been higher than expected – nearly 95%.
Given high compliance levels, the market has now turned to focus
on the question of whether the cut will be extended beyond the
June 30, 2017, expiry. We think it will.
The current term structure of the Brent oil futures contract seems
to suggest that the market believes that OPEC will extend its
supply cuts beyond that initial end date. A flip in the crude oil
market structure has preceded a price rally during the past two
crude oil market cycles. Market participants will watch closely to
see if this one does, too.
10 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
A flip in the crude oil market structure has
preceded a price rally during the past two crude
oil market cycles. Market participants will watch
closely to see if this one does, too.”
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