Kate Mackenzie Oil market contango diminishes

Which is not to say it’ll actually go away any time soon.

The spread between forward prices and spot prices for crude oil is narrowing towards 18 month lows. Lower inventories amid higher demand, particularly from Asia, are seen as the main reasons. Barclays Capital analyst Amrita Sen sees the narrowing spread in the context of higher front month prices:

With global crude inventories being slowly whittled away and concerns of floating storage diminishing greatly, the groundwork for a slight flirtation of prompt contracts with backwardation in early Q2 is being laid. Moreover, in our view, the oil market is transitioning away from the long-held period of $70-80 range-bound trading to a higher trading range. Having settled above $80/bbl for the third day running and currently trading near $82 with relative ease, it does seem to have become relatively easier for prices to test and break past $80.

Will there be a full move into backwardation, in which front month contracts attract a premium, or will the contango simply flatten? The FT’s Greg Meyer writes that while some analysts believe we will soon see backwardation, physical traders think it is less likely:

Physical commodities merchants say forward and spot prices will slowly converge, though they do not see imminent backwardation. “We see the contango dissipating,” says Ricardo Leiman, chief executive at Noble, the Hong-Kong based trader.

But other views are around too. John Kemp pointed out recently that regardless of the gap, in the past few years a change has taken place that means forward prices are driving the spot price momentum.

In the more immediate sense, Philip Verleger believes tensions over Iranian sanctions – including China’s own fears – are driving the flattening:

Buyers will add precautionary stocks any time they get worried about supply security, and today it is inexpensive to buy given the low cost of money.

Meanwhile, we wonder what effect a shift to backwardation might have on the retail energy commodity investors who have continued to pile into passive funds in the past two years. Under contango their holdings have effectively fallen each month with the ‘roll’ into new funds; what counter-intuitive fun might be had soon?

Related links:

Oil prices poised for backflip as stockpiles diminish (FT)
How financial traders changed oil markets (FT Energy Source)
Why buy and hold can be a disaster in commodities (FT Alphaville)