Contango and oil prices
On May 2, 2017, June 2017 crude oil (DBO) (OIIL) (USL) futures were trading at a discount of $1.5 to June 2018 futures contracts. The situation, referred to as “contango” in the crude oil futures market, 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. The crude oil forward curve switched to a contango structure in November 2014. Since then, crude oil active futures have fallen ~39.5%.
Backwardation and oil prices
On the other hand, when there’s immediate demand for crude oil, active crude oil futures trade at higher prices than the futures contracts for the months ahead. This causes the crude oil futures forward curve to slope downward, and such a situation in the crude oil futures market is referred to as “backwardation.”
Historically, periods of strong crude oil prices have coincided with a backwardation structure. Crude oil (SCO) (UCO) (DWTI) active futures closed at a historic high of $145.29 per barrel on July 3, 2008, after an almost one-year period of backwardation in the oil market.
Active crude oil futures traded at a premium of $9.77 to 12-month futures contracts at their peak on November 2, 2007. As the forward curve switched to contango over the course of the following year—with active futures hitting a discount of $24.45 to 12-month futures contracts in January 2009—crude oil prices fell 75.6%.
For this reason, the shape of and changes in the futures forward curve in the oil market could be hinting at coming changes in oil prices.
Crude oil forward curve dynamics
After OPEC’s (Organization of the Petroleum Exporting Countries) historic deal in November 2016, the spread between active futures and 12-month forward futures started to flatten. On February 23, 2017, WTI (West Texas Intermediate) crude oil active futures were at their highest levels since July 6, 2015.
Due to rising US oil production and record oil inventory levels, the spread again started to widen on February 23, 2017. Since then, crude oil has fallen ~12.5%.
In the past week, crude oil prices have fallen 3.8%, but the spread has contracted from $1.53 to $1.5. The fall in the contango spread could point to lessening concerns about crude oil’s demand-supply imbalance. This change could mean that the market sees stronger prices ahead in the spot crude oil market.
The crude oil forward curve’s dynamics can also have implications for oil storage and transportation MLPs (AMLP). The curve’s dynamics can impact upstream oil producers’ (XOP) hedging decisions, and 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. However, this could change if the oil market switches to backwardation.