More Balanced Oil Market Expected in 2nd Half

Professional commodity traders watch spreads (differences between the prices for adjacent futures contracts) rather than spot prices as the best indicator of the balance between supply and demand.

In crude, the narrowing spreads for both Brent and West Texas Intermediate (WTI) indicate a closer balance between supply and demand in the second half of the year than in the first.

Periods of excess supply are normally characterized in futures prices by a “contango” structure, an obscure term that originated in the 19th century.

In contango, contracts for deferred delivery trade at a premium to the spot price to compensate the seller for the costs of financing, storing and insuring the product before delivery.

By the middle of February, the futures market for crude was trading in a wide contango, reflecting the steady rise in U.S. commercial crude stockpiles and fears onshore storage space would run out.

The contango was particularly pronounced in futures contracts linked to WTI because the rise in stocks has been concentrated in the United States, especially around the contract’s delivery point at Cushing, Oklahoma.

On Feb. 26, the December futures contract was trading at a premium of $6.21 over WTI futures for delivery in June.

On March 18, the Jun-Dec spread was still trading at $6.16 per barrel, paying more than $1 per barrel per month to cover the cost of storing and financing oil in the second half of the year.

Since then, however, the Jun-Dec spread has tightened to $3.83 per barrel, just 64 cents per month, and is at its narrowest since early January.

Something similar has happened with the Jun-Dec spread in Brent, though in the case of the international oil benchmark, the spread began to narrow from the middle of February onwards.

LOOKING BEYOND INVENTORIES

A narrowing of the contango is usually associated with market expectations that the degree of oversupply will fall in future.

In the case of crude, however, the contango has narrowed even as U.S. commercial stockpiles have climbed to the highest level in more than 80 years.

U.S. commercial crude stocks have risen by almost 97 million barrels, around 25 percent, since the start of 2015, according to the U.S. Energy Information Administration (EIA).

Reported crude stocks increased by nearly 11 million barrels last week alone, the largest one-week build for 14 years. It was the tenth-largest build reported since the EIA began publishing weekly information on crude stocks back in 1982.

Yet the contango spread has continued to tighten, suggesting physical traders are looking past short-term oversupply to a tighter supply-demand balance in the second six months of the year.

FALLING SUPPLY, RISING DEMAND

The number of rigs drilling for oil across the United States has dropped by more than 50 percent in the last six months, which should cut production by several hundred thousand barrels per day later in the year.

On the demand side, motorists are using their cars more and the United States is likely to witness the strongest summer driving season since 2008, boosting fuel consumption.

Stockpiles of fully refined and semi-finished petroleum products are higher than normal but nowhere near as distended as crude stocks.

While U.S. crude stocks are almost 125 million barrels (35 percent) higher than the previous 10-year median, product stocks are only 68 million barrels (10 percent) above average.

To put that in context, the United States consumes around 19 million barrels of refined products per day, with slightly more in summer than in spring and autumn.

U.S. refiners are taking advantage of the wide spread between the price of domestic crude oil and finished fuels to maximize production.

Throughput is currently almost 16 million barrels of crude per day, more than 1.3 million barrels per day above the 10-year average, and 600,000 barrels per day above the level this time last year.

MARKETS ARE NOT INFALLIBLE

The fact the Jun-Dec contango has narrowed so sharply despite the continued rise in stocks is probably the most unusual feature of the market at present.

It strongly suggests traders are expecting the degree of oversupply to fall over the second half of 2015 with a much closer balance between supply and demand.

The market could be wrong, of course. Traders and investors wrongly assumed political risk and violence in the Middle East would reduce supplies in the second half of 2014. When the expected disruptions failed to materialize, spot prices plunged.

The market could be making a similar mistake in 2015, overestimating the pickup in demand and fall in U.S. supplies, in which case there will have to be a sharp adjustment in both spot prices and the spreads.

For now, however, the balance of market opinion favors the idea that the worst of the oversupply situation is over.