The Oil Market Is Flirting With Backwardation. It’s a Bullish Sign. - Barron\'s PDF

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The Oil Market Is Flirting With ‘Backwardation.’ That’s a Positive Sign. By Avi Salzman

May 21, 2020 1:42 pm ET

Oil prices have been trading in a pattern known as contango this year, where spot prices and near-term futures are worth less than futures expiring several months from now. Demand is weak today because fewer people are driving and flying, but it will likely be higher in later months as economies open up from Covid-19 restrictions. Photograph by Getty Images

The contango in the past few weeks was so steep—futures for oil to be delivered in June briefly traded at half the value of January 2021 futures, for instance—that analysts were calling it “super contango.” When oil went negative on April 20, the spread between the May and June contracts was as wide as $58, an unprecedented gap. But suddenly this week, the super contango pattern shifted into a pattern called backwardation, if only briefly. Backwardation means oil today is worth more than oil in the future. As June West Texas Intermediate crude futures were about to expire on Tuesday, they actually traded higher than July futures, by as much as 90 cents per barrel. With WTI trading at about $30, that 90 cents is significant. Backwardation is theoretically a bullish sign for oil, because it means traders no longer have an incentive to store oil and sell it at a later date. Instead, it’s best for them to sell oil now because prices could be lower in the future. Is it bullish today? The answer is a qualified yes. In the current pandemic, backwardation is a somewhat trickier sign, because oil use is depressed and likely will remain that way. But it is at least a sign of somewhat better times for producers. Factors aside from prices for oil futures point to a healthier market, though one that hasn’t fully healed. Analysts had been predicting that oil demand would be depressed for months as lockdowns slowly lift. But early signs have pointed to a slightly faster recovery in the global economy, and thus in oil demand. In some Chinese cities, for instance, auto traffic is actually higher than it was before the pandemic hit. Production has also declined quickly, with cuts in Saudi Arabia and other countries keeping excess oil off the market. Inventories in the U.S. have been declining faster than analysts had been expecting, meaning that the oversupply may not be as drastic

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Oil stocks have been on a tear, with Chevron (ticker: CVX) rising 55% in the past two months and the Energy Select SPDR ETF (XLE) up 52% in that period. WTI prices were on their way to a sixth straight day of gains on Thursday, rising 2.1% to $34.18. Oil futures tend to rise after backwardation begins, according to a PIMCO analysis in 2017. “The shape of the oil curve has historically been one of the best predictors of future returns, so the move to backwardation has significant implications for commodity investors,” PIMCO portfolio managers Nicholas Johnson and Andrew DeWitt wrote at the time. “For example, subsequent four- and 12-week returns for long oil futures positions in backwardated oil markets have averaged 1.3% and 2.9%, respectively, compared with returns of -1.7% and -3.8% for the same periods during contango markets.” To be sure, backwardation may not be here to stay. After that brief shift into backwardation when the June contract expired on Tuesday, the market settled back into contango and has remained there. At Wednesday’s settle, WTI futures for July delivery traded at $33.49, while futures for January delivery were at $35.48. “S&P Global Platts Analytics believes backwardation is not sustainable in the near term and that WTI’s structure should stay in contango, despite all the supply cuts in North America,” said Rick Joswick, head of oil pricing and trade-flow analytics at S&P Global Platts. But with the curve so much flatter now, backwardation has at least become a realistic possibility. A shift from super contango to backwardation in a matter of weeks would shock the market. Super contango, after all, forced the leading exchange- traded-fund for oil futures to completely change its investment strategy. That product, the United States Oil Fund (ticker: USO), has historically invested entirely in the front-month contract, shifting to the next month two weeks before expiration. But when the market is in contango, that shift is expensive: The front month is less expensive than the following one, so the fund has to sell cheaper futures and buy more expensive ones. USO responded to the super contango and overall disruption in oil markets by shifting its assets into longer-dated contracts. Backwardation could inspire a shift back because it would have the opposite effect. Rolling the contract forward each month would entail selling high and buying low, the kind of dynamic that investors like. That could theoretically make USO a more attractive option for investors going forward. A USO spokesperson wrote that the fund’s investment strategy could change in the future. There are certainly negatives to this change. For oil companies, backwardation could complicate hedging strategies that had depended on oil rising considerably in later

Search News & Quotes Magazine Data Advisor Penta Topics The curve is flattening, but the reasons for the shift aren’t entirely encouraging. Supply and demand for the immediate future are more balanced, lifting nearby prices, while longer-dated futures have stayed pretty stagnant. That indicates investors expect prices to remain low overall. Oil prices of $35 for January 2021 aren’t high enough to fund producers’ expansion plans. They need $45 oil or more to make money in the longer-term. But on the margins, the move toward backwardation has been bullish, because it points to a healthier market where demand is returning. Oil stocks are lately surging, though most remain about 20% lower for the year. A more dramatic reversal would make most investors happy. Write to Avi Salzman at [email protected]

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