After my macro wrap this morning, I figured I’d stay on the topic of oil as it hovers near multi-year highs. The most interesting aspect of the rally in WTI (West Texas Intermediate, the U.S. benchmark contract) crude oil over the past month has been the rapid move from contango to backwardation.
For those unfamiliar, contango is a term for futures markets where each subsequent maturity is at a higher price. So the first month is a lower price than the second month, which is a lower price than the third month, and so on. We’ve discussed contango with regards to VIX Futures on numerous occasions (and its implication for VIX-related ETFs like VXX).
WTI crude oil has been in contango for most of the past 4 years. But since late April, it has been in backwardation (where each subsequent maturity is at a lower price on the futures curve). Since late June, it has been in severe backwardation, a situation that has not occurred since the go-go days of late 2007 / early 2008 for the oil market. Here is the 7 year chart of the difference between the six month WTI contract and the front month WTI contract:
The green shading represents contango, when the front month contract is lower than the 6th month contract. The red shading represents times of backwardation, when the front month contract is higher than the 6th month contract. The market is currently in its most backwardated position in that entire period. Why such an extreme situation, especially since oil inventories are actually above historical averages for this time of year?
First off, it’s worth noting that the Brent crude oil market (the European benchmark) has actually been in backwardation for much of the past 2.5 years. The main catalyst that moved the market from contango to backwardation was the Arab spring, which cut supplies to the European market. Since that event, Brent crude oil traded at a large premium to WTI crude oil. Until the past couple months. Now the contracts are about evenly priced.
One major reason for the convergence between Brent and WTI crude oil has been the opening of more transit pathways for American oil (particularly from the storage facilities in Cushing, Oklahoma, where the WTI contract is settled). That has relieved some bottlenecks that has allowed American oil to be more easily and cheaply transported to international markets, leading to price convergence.
The shifts in the futures markets for both contracts in the past few years has been led by supply side developments rather than large moves in demand. In that sense, the short-term price moves in the oil market might be more impacted by supply-side constraints. However, the Economist is probably correct that, in the long-term, the shift in demand away from oil matters more than any supply concerns.