Waiting for Back Ended Oil Contango to Normalize
Exploration and Production (E&P) stocks seem to be still pricing in $60-70 oil in the longer term. However December 17 and Dec 18 futures are trading around $54 and $57 respectively. So I’m still waiting for E&P stocks to fall further. But we’re getting there.
Term structure of futures is supposed to tell you market’s future view of storage capacity, cost, and inventory. These things are in turn dependent on the market’s forward view of production and consumption.
Crude oil is currently in an oversupply position so I’m not surprised that the front end of WTI futures (CL) is showing some contango. But this condition extends to the back-end too. Below shows how the spread between Dec 2018 and Dec 2016 evolved over the past year. (This is Dec 2018 minus Dec 2016, so higher = contango).
I read this as the market saying oil will be way oversupplied even in December 2016, thus demand for storage will still be high (implying the market still expects a turnaround in oil by December 2018). That seems inconsistent. By 2H16, if we still have an oil glut I would think the market would be convinced that cheap oil is here to stay (perhaps due to technological advances lowering marginal cost of a barrel), then the back ended futures should come down as well. Term structure should normalize.
I would prefer betting on term structure to normalize than taking a pure directional view. Maybe short Dec 2018 futures and buy Dec 2016 and just keep them there. This would be better than trying to pick a bottom by going long front end futures (and risk sell low / buy high on each rollover)
- Trade buyers: well stocked already so no one wants more oil now. Value of convenience is low.
- Trade sellers: low need for insurance (else they would have sold futures and push back-end future prices down)
- Storage providers. Inventory level is high and storage capacity could be running out. So storage cost is bid up.
- Speculators and arbitrageurs. Their actions could just be trend following or be based on nuanced view of future balance.
Some people (like Gartman here) argue that futures term structure have NOTHING to do with future expectations of prices, but just a function of supply/demand and storage cost. That sounds like a smart thing to say but they are really just playing on semantics. All supply and demand have some element of participants’ future expectation - if oil trades at $10 and you expect spot prices to be $100 a year from now, you would buy now, store some oil and sell in the future. You would not only impact the supply and demand of oil, but also bid up storage cost in the process.