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Contango in Oil Is Falling: What Could It Mean for Prices?

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Contango and oil prices

On May 17, 2017, June 2017 crude oil (DBO) (OIIL) (USL) futures contracts were trading at a discount of $1.47 to June 2018 futures contracts. This situation is referred to as “contango,” and is represented by an upward sloping shape on the futures forward curve.

Historically, periods of weak crude oil prices have coincided with this contango structure. In November 2014, the crude oil forward curve switched to a contango structure. Since November 2014, US crude oil active futures have fallen ~37.7%.

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Backwardation and oil prices

In contrast, when there’s immediate demand for crude oil, active crude oil futures trade at higher prices than the futures contracts for the upcoming months, which makes the crude oil futures forward curve slope downward. This situation in the crude oil futures market is called “backwardation.”

Historically, periods of strong crude oil prices have overlapped with backwardation. US crude oil (SCO) (UCO) (DWTI) active futures closed at a record high of $145.29 per barrel on July 3, 2008, after almost one year of backwardation in the oil market.

While the shape of the futures forward curve can reflect the demand-supply situation in the oil market, changes in the shape could hint at coming changes in oil prices.

Crude oil forward curve dynamics and implications

Between May 10 and May 17, the spread contracted from $2.09 to $1.53, while crude oil prices rose 3.7%. The decrease in the contango could point to an easing of concerns about crude oil’s demand-supply imbalance, which could have helped push prices higher.

The crude oil forward curve’s dynamics can have implications for oil storage and transportation MLPs (AMLP). The forward curve can impact upstream oil producers’ (XOP) hedging decisions. Its dynamics can also have important implications for the performance of commodity-tracking ETFs such as the United States Oil ETF (USO).

Due to the current contango structure in the oil market, USO has underperformed crude oil prices. In the next part, we’ll discuss how the contango structure impacts the fund’s performance.

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