‘Contango’ in oil futures may soon give way to ‘backwardation’
Less than three weeks after a soon-to-expire U.S. benchmark futures contract made history by trading below zero dollars for the first time ever, there are signs that the market may soon shift from a surplus to a shortage of crude, one analyst argued Thursday.
The potential shift comes as the market sees a condition known as contango, in which later dated futures are bid higher than nearby contracts, signaling a near-term glut and providing an incentive to store a commodity away for future use, giving way to backwardation, in which the spot price and nearby futures are bid higher than contracts for later delivery, said Robert Yawger, director of energy at Mizuho Securities U.S.A., in a note.
Front-of-curve contango spreads in West Texas Intermediate crude, Brent crude, and reformulated gasoline are “narrowing quickly, and are within one day striking distance of backwardation,” Yawger wrote.
That would mark a full reversal from the price pattern seen just last month, when WTI prices for future delivery rose well above the spot market. The now-expired May WTI contract settled at a negative $37.63 a barrel on April 20.
Read:Oil market in ‘super contango’ underlines storage fears as coronavirus destroys crude demand
Contango in the oil market can encourage investors to put oil into storage for later sale. That has contributed to concerns over rising storage levels and shrinking storage capacity.
Read:The oil market is running out of storage space and production cuts loom
“There is an ocean of supply out there…at best demand is crawling back,” said Yawger, in a note Thursday. “But there is no denying that the market is tightening.”
“Whatever the reason, the market is telling us we are getting close to switching from surplus to shortage,” he said.
“Backwardation discourages storage. It encourages withdrawal from storage to satisfy demand,” explained Yawger. “The lower storage gets, the less storage can serve as a shock absorber for higher prices, the higher prices go at the front of the curve, the wider the backwardation gets.”
On Thursday, the front-month June WTI crude futures contract CLM20+4.63% settled at $23.55 a barrel on the New York Mercantile Exchange. The most-active July WTI contract CLN20+4.27% finished the session at $24.83.
At one point Thursday, the “June/July spread traded to a five week high of -$1.05,” said Yawger, after Saudi Arabia oil giant Aramco raised its crude oil official prices, or OSP, prompting a rally in WTI prices, which fizzled out by the settlement. “The spread has posted a new high for seven days in a row. The spread traded to a contract low of -$10.99 on April 21, or just 12 trading days ago,” he said, adding that the front of the curve has not traded in backwardation since March 16.
Futures prices for Brent crude has climbed in recent days after the production cuts by the Organization of the Petroleum Exporting Countries and its allies took effect on May 1.
The Brent July/August spread has traded higher every day since the start of the month and “traded at a five-week high of -$0.67” at one point Thursday, said Yawger. “That is one big day from switching from contango to backwardation, he said, noting that the front of the curve Brent spread has not traded in backwardation since a contract-expiration spike on April 30.
July/August contango is “narrowing quickly,” he said. On Thursday, July Brent crude CLN20+4.27% settled at $29.46, while August Brent finished at $30.40.
Meanwhile, reformulated gasoline futures made a strong bid to be the “first part of the oil patch to switch from contango to backwardation, with the June/July spread trading to an eight week high of -$0.10” during Thursday trading, said Yawger. June reformulated gasoline futures RBM20+1.02% ended Thursday at 93.14 cents a gallon, while August futures RBQ20+1.59% finished at 93.71 cents a gallon.
“The RBOB spread caught a bid in recent days after two straight [Energy Information Administration] gasoline storage draws,” Yawger said. Gasoline was an all-time high of 263.2 million barrels just three reports ago, he said, but four-week gasoline demand increased by a record amount in Wednesday’s report.
“All-time storage appears to be a distant memory, and the increase in demand is driving the market,” he said. If RBOB gasoline is the first to cross from contango to backwardation, that “would be a major landmark on the road to recovery for the energy patch” because “if there is demand for gasoline, there is going to be demand for crude oil.”