LONDON (Reuters) - Global oil markets are gradually rebalancing, but progress has been slower and more uneven than the Organization of the Petroleum Exporting Countries and bullish hedge funds expected.
OPEC as well as most commentators, crude traders and hedge funds have assumed the rebalancing of the oil market will be accompanied by a shift from contango towards backwardation in oil futures prices.
Officials at the producer group have focused on the shift to backwardation as a key indicator of whether their policies are working.
Hedge funds and physical traders appear to have been trading around the futures curve as they speculate on when and how quickly the oil market will tighten.
But OPEC officials acknowledged in Houston last week that the rebalancing and the shift to backwardation had not proceeded as fast as they had hoped.
Now there are fears that the resurgence of U.S. shale production could throw the process off course entirely.
For oil traders and analysts, the strip of futures prices provides the most commonly employed indicator of the changing balance between production, consumption and stockpiles.
If production exceeds consumption, and stocks are high and rising, prices for oil delivered in the near term trade at a discount to prices for oil delivered further in the future.
The price structure, known as contango, reflects the extra costs of buying oil now only to store it until needed later.
The main costs associated with storing crude are the cost of borrowing money and the cost of owning or leasing space in a tank farm or tanker.
In the opposite situation, where consumption exceeds production and stocks are low and falling, oil delivered in the near term will trade at a premium to that for future delivery.
The price structure, known as backwardation, reflects the premium buyers are willing to pay to own oil now and avoid the risk of failing to secure sufficient supplies.
The relationship between the cost of borrowing money and leasing tank space on the one hand, and the premium for immediate availability on the other, determines whether futures trade in contango or backwardation.
In a heavily oversupplied market, the premium for immediate availability falls to zero, and the shape of the futures curve is determined entirely by the cost of finance and storage, ensuring futures prices are in contango.
But as the market becomes less oversupplied, or even undersupplied, the premium for immediate availability rises and starts to offset the discounts for finance and storage.
If the supply-demand-stocks balance tightens sufficiently, at some point the premium for immediate availability becomes bigger than the discounts for finance and storage, and futures prices move into backwardation.
Holbrook Working of Stanford University’s Food Research Institute explained the relationship between stock levels and futures prices more than 80 years ago (“Price relations between July and September wheat futures”, 1933).
Working was examining grain markets, but the same relationships are present in the market for any storable commodity.
Similar price relationships are evident in spot and forward prices for wine and whisky, natural gas, gasoline and crude oil.
Over the last 25 years, the calendar spreads between Brent crude futures for adjacent months have provided a reasonably reliable signal about the shifting balance between production and consumption (tmsnrt.rs/2mnwWS9).
Periods of oversupply such as 1996-1998, 2008-2009 and 2014-2016, have seen Brent spreads move into contango.
Periods of undersupply, such as 1999-2000, 2006-2008 and 2010-2011, have seen the spreads move towards backwardation.
But the shape of the futures curve also provides an opportunity for traders to speculate against the prevailing market consensus. “The futures curve is what we bet against,” as one experienced trader puts it.
Traders who believe the supply-demand balance will be tighter than commonly expected can speculate on a move towards backwardation by taking a long position in the calendar spreads.
Buying nearby futures contracts while selling futures further forward, bullish traders profit if nearby prices move higher relative to further forward prices.
Conversely, traders who believe the supply-demand balance will be less tight can bet on a move towards contango by taking a short position in the calendar spreads (short nearby futures and long forwards).
The futures curve is a good indicator, but like any market-generated price there can be a lot of short-term volatility (noise) around the long-term trends (the signal).
The big picture is that the oil market has been gradually rebalancing since 2015 but progress has been fitful.
Brent spreads have been progressively tightening since February 2015 but there have been several major setbacks including during the summer and autumn of 2016.
Output cuts agreed by OPEC and non-OPEC exporters towards the end of 2016 were expected to speed up the process.
Spreads tightened significantly between the end of November, when the OPEC accord was announced, and Feb. 21 (tmsnrt.rs/2njjPXm).
Since then, the calendar spreads have weakened. Hedge funds and some other traders seem to have over-anticipated the speed at which the market would rebalance, causing spreads to tighten then recoil.
Spreads between Brent futures contracts for different months in the second quarter of 2017 have been especially volatile, probably as a result of speculative trading (tmsnrt.rs/2mnlXIG).
Despite the recent setback, the Brent spreads are still much tighter than they were before the announcement of the OPEC deal.
The contango between the first listed futures contract and the seventh listed contract has narrowed from $3.80 per barrel on Nov. 29, the last day before the OPEC meeting, to just 84 cents per barrel on March 13.
The critical question now is whether rebalancing will continue or be driven off course by the resurgence of U.S. shale.
If rebalancing continues, the market should start to draw down stockpiles in the second half of 2017 and through 2018, which would support a further shift towards backwardation.
But if rebalancing is driven off track, the current contango structure will probably prove too narrow, and nearby futures could sell off sharply.
(John Kemp is a Reuters market analyst. The views expressed are his own.)
Editing by Dale Hudson