10 May

What Oil’s Rising Contango Tells Traders

WRITTEN BY Rabindra Samanta

Contango and oil prices

On May 9, 2017, June 2017 crude oil (DBO) (OIIL) (USL) futures were trading at a discount of $2.4 to June 2018 futures contracts—the highest discount since March 22, 2017. This situation in the crude oil futures market, which is referred to as “contango,” is represented by an upward sloping shape on the futures forward curve.

What Oil’s Rising Contango Tells Traders

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 ~41.8%.

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. Such a situation in the crude oil futures market is referred to as “backwardation.”

Historically, periods of strong crude oil prices have coincided with backwardation. 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 premium of active futures over the futures contract 12 months ahead started to reduce. 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 ~15.7%.

In the past week, the spread expanded from $1.5 to $2.44, while crude oil prices fell 3.7%. The rise in the contango spread could point to a rise in concerns about crude oil’s demand-supply imbalance. This change could mean that the market sees lower prices ahead in the spot crude oil market.

Forward curve implications

The crude oil forward curve’s dynamics can also have implications for oil storage and transportation MLPs (master limited partnerships) (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.

Now let’s examine the inventory spread.

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