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Oil Contango: How Should Oil Traders View It?

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Oil contango

Between May 30 and June 6, 2017, US crude oil (USL) (OIIL) July futures fell 3%. On June 6, 2017, US crude oil July 2018 futures were trading at a premium of $0.7 to July 2017 crude oil futures. On May 30, 2017, the premium between the two futures contracts was at $0.68.

The upward sloping shape on the futures forward curve is called “contango.” In the last decade, oil prices were weaker during contango. Between November 3, 2014, and June 6, 2017, US crude oil active futures lost 38.8%.

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Backwardation

When the forward curve slopes downwards, the situation is called “backwardation.” A sudden spike in oil demand because of a supply disruption or any other factor could force the futures spread to switch to a discount.

In contrast to a contango scenario, oil prices were stronger during backwardation. For example, the year-long period of backwardation during 2007 and 2008 pushed US crude oil active futures to a record level of $145.29 per barrel on July 3, 2008.

The slope of the forward curve could hint at possible changes in crude oil demand and supply dynamics.

Will supply-demand concerns ease in the future?

On a week-over-week basis, the premium of US crude oil July 2018 futures over July 2017 futures has risen. The rise in the premium could indicate concerns around supply and demand. US crude oil active futures fell 3% between May 30 and June 6, 2017. Other factors that we discussed earlier in this series could explain the fall.

ETFs

Due in part to the contango structure, the United States Oil Fund LP (USO) underperformed US crude oil futures in the last few years. Energy MLPs (AMLP) are mostly engaged in oil storage and transportation, so oil’s forward curve could impact them. Oil’s forward curve could also influence upstream oil producers’ (XOP) hedging decisions.

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