Oil futures have started trading in a pattern that historically has been a bad sign for prices.
It is known as “contango,” and it means that prices for oil futures contracts that expire several months from now are higher than prices today. Futures expiring next month on
West Texas Intermediate crude,
the benchmark grade in the U.S. oil market, are trading for $72.11 a barrel.
Those expiring in June are going for $73.05 a barrel. Even November 2024 WTI futures are higher than current prices, a sign that traders expect the trend to last.
On its face, contango can look bullish because it seems to imply that people think prices will rise in the future. But in practical terms it means that there isn’t enough demand to sop up all the supply in the market today, giving investors an incentive to store barrels of oil to sell later, rather than unloading them now.
And the current dynamics of demand and production indicate the oversupply could persist for a while, a bad sign for oil investors.
Contango is associated with negative returns for bets that oil prices will rise, according to a 2017 article by Pimco portfolio managers Nicholas Johnson and Andrew DeWitt. A shift into contango is associated with an average return of negative 3.8% for bullish oil-futures positions in the following three months, Johnson and Dewitt found.
The last time oil was in contango for a sustained period was in 2020, at the height of the pandemic. At the time, there was little demand for oil because most people were staying home, but investors expected both demand and prices to rise. At its widest point—when West Texas Intermediate oil futures briefly went negative—the difference between near-term and long-term prices was as large as $72, according to Denton Cinquegrana, chief oil analyst at OPIS.
But the futures curve switched into a pattern known as backwardation late in 2020, and has mostly held there over the past three years. In backwardation, near-term prices are higher than contracts expiring far in the future.
In late 2020, demand had started rising again as Covid restrictions eased, but production was returning slowly because of OPEC cuts and gradual growth from U.S. producers. It made sense for companies to produce oil and sell it as soon as possible. The value of oil investments surged in 2021 and 2022, with prices and stocks rising for most of that period. Oil companies posted record earnings in 2022.
The return of contango could spell problems for oil companies in early 2024. OPEC and its allies, such as Russia, have attempted to buttress the market by collectively cutting production by around 5 million barrels a day, or about 5% of total demand. But the latest reductions, announced this month, haven’t worked.
Oil prices have mostly been falling as supply outside of OPEC continues to rise. Inventories of oil have been filling up.
That doesn’t mean that the trend can’t reverse again, or that oil can’t rise when it is in a contango pattern. In fact, one analyst has been arguing that the contango pattern doesn’t signal bearishness this time.
Roth MKM’s Leo Mariani wrote in a Wednesday note that the latest shift in the oil market is driven more by a change in how oil trading works than by the natural dynamics of supply and demand.
His thesis looks at the market structure for oil futures products. The increasing popularity of exchange-traded funds that buy oil futures and an increase in oil speculators have changed how the commodity is traded, Mariani wrote. Companies like oil producers and refiners have been hedging less as prices have stayed high and refinery margins have been strong. So oil futures are now used more for speculation.
“These groups now control the majority of daily trading in oil, and these types are less focused on supply and demand and more focused on following the latest trend that the chart indicates,” he wrote.
Speculators tend to trade near-term contracts. When speculators sold futures contracts in recent days, it caused the front end of the curve to fall. That bearishness wasn’t reflected as much in the longer-dated futures, leading to the contango, in Mariani’s view.
Thus, a futures curve controlled by speculators isn’t a real signal about supply and demand.
“The bottom line for us is we think the current contango structure can actually be bullish for oil,” Mariani writes, “given that speculative interest and trend followers have washed out of the commodity and leaving the risk on prices to the upside if these players get back in at some point.”
Write to Avi Salzman at [email protected]
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