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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 || 7 y-1 ar 6 16 nu y-1 ly- 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 Ja Ju ar Ja nu 5 15 y-1 ly- ar Ju 4 4 nu y-1 ly1 Ja ar Ju nu 3 y-1 Ja ar Ju ly- 2 nu Ja y-1 ly1 Ju ar nu y-1 ly- Ja ar nu Ja Ju 0 y-1 ar Ju ly1 9 Ja nu y-0 ly0 ar Ju nu y-0 ly- ar Ju Ja 7 nu Ja y-0 ly0 ar Ju nu Ja 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.” Issue 1 2017 11 This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. 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