HOUSTON (Reuters) - The growing gloom that sent oil markets reeling last week appears to be much more than a short-term phenomenon.
Oil contracts for 2018 and beyond, normally slow to follow fluctuations in more speculative short-term prices, have also collapsed amid a 10 percent dive in immediate delivery futures, reflecting a deepening pessimism over the long-term outlook for a battered industry.
U.S. crude futures are now trading at below $50 a barrel through the end of 2019, a level at which most shale drillers would struggle to turn a profit. No futures contracts - which are currently dated to 2024 - are priced above $54 a barrel. Just a few months ago many analysts and executives expected oil prices to rebound to at least $60 within a few years.
But in an unusual twist, the long-term outlook has deteriorated almost as quickly as short-term fundamentals as more and more investors come around to Goldman Sachs’ view of a downturn far longer-lasting than anyone expected.
The sell-off shows traders “continue to price in that we have a very serious global oversupply situation,” said Michael Wittner, global head of oil research at French bank Société Générale. “It’s going to take a long time to work it off.”
At midday on Monday, front-month oil futures had fallen by more than $5.60 a barrel, or roughly 15.5 percent, since last Monday to around $31.00 a barrel, while West Texas Intermediate oil futures for delivery in December 2017 slipped by $4.35, or roughly 9 percent, to $43.33 a barrel. At the same time, the 2018 contract has dropped by $4.14 a barrel, or more than 8 percent, to $46.6 a barrel - unusually steep declines that cut both to contract lows. [O/R]
Though less liquid, longer-term contracts are typically not as volatile as those at the front end of the curve and are often less sensitive to the short-term factors that prompt fluctuations in oil markets, such as swelling stockpiles, geopolitical uncertainty or financial market flux.
The back of the curve tends to be seen as a better indicator of long-term supply and demand fundamentals, a rough gauge of the marginal cost to produce oil and a point of mean reversion - in which prices eventually move back toward the average - amid the industry’s boom-bust cycles.
For example, seven years ago, at the nadir of the last oil price crash, while prompt futures contracts in early January 2009 were falling by more than 15 percent in a month’s time, those for delivery periods a year out or later declined by no more than 2 percent. Back then, the contango - in which later month periods are at a premium to the prompt month - was much deeper.
The past year and into last week, that has not been the case, in large part because of the unexpected and ongoing resourcefulness of U.S. shale oil drillers, the world’s de facto swing producers after Saudi Arabia refused to cut output.
Ailing from the oil slump, they have cut drilling costs and increased efficiency far more than expected. Once estimated at $60 a barrel or more, the industry’s average breakeven cost is now roughly $47 a barrel, according to a Wells Fargo study of some four dozen U.S. energy companies.
“One thing we’ve seen in the last 18 to 20 months is that people are more efficient, which has lowered breakeven prices. That’s going to feed out the curve and lower expectations going forward,” according to John Saucer, vice president of research and analysis at Mobius Risk Group in Houston.
Some of those producers have used long-dated futures to protect their revenues for the months or years ahead. Last week, however, there was little evidence of their activity in the market, suggesting the activity was fueled more by investors.
Drillers, for the moment, have yet to fully embrace the idea that prices may languish below $50 for a while, according to a Goldman Sachs research note published after the bank hosted a closed-door energy conference this week.
“Investors were looking for fear and trepidation from producers but got agility and below-expected clarity instead,” according to Friday’s research note.
Some hedge funds also invest in the long end of the market, though they have not fared well. Andrew Hall, one of the industry’s most famed oil market bulls, suffered a 35 percent loss last year, CNBC reported.
To be sure, the far-forward oil market is not the indicator it used to be, in part due to reduced liquidity.
Trading activity last week was fairly average, suggesting any changes in position may have been modest. The Dec 2017 contract saw around 9,000 lots a day of trade, less than in early December. By contrast the prompt February contract turned over more than 500,000 lots a day, data show.
“The further out you go, the less liquid it is. You don’t need that many people selling to see some price movement,” Wittner said.
Changes to the nature of the market in the wake of financial reform measures that pushed out banks and funds - participants who previously provided liquidity to longer-dated contracts - have largely contributed to that lack of liquidity, leaving the back end of the curve more exposed to fluctuations in prompter contracts.
“What we are left with is some hedging in the middle of the curve, rather than the back, and the surviving banks, much reduced in scale, now holding the off-setting short positions,” Paul Horsnell, head of commodities research at Standard and Chartered said.
Reporting by Liz Hampton; Editing by Cynthia Osterman and Dan Grebler