Backwardation: How to Play the Moving Oil Market
by Tony Daltorio, Investment U Research
Wednesday, March 17, 2010
Investors who want to know the near-term course for oil prices can simply check out the futures market, where buyers and sellers bid on commodities intended for later delivery.
In particular, the Nymex light sweet crude oil futures’ curve has flattened.
Late last year, a barrel of immediately deliverable U.S. oil cost a whole $2.35 less than a barrel due a month later. Today, that spread has narrowed to about $0.35.
Oil prices haven’t matched that closely since practically a year and a half ago. Yet the spread looks ready to narrow even further, perhaps even flipping to where spot prices are higher than their futures.
Investors call that kind of inverted price pattern, backwardation. And if it happens again, it will mark the first time since mid-2008.
Crude Oil: Backwardation and Contango
Storage levels affect commodity futures patterns. If oil abounds, the market naturally doesn’t run any great risk of supply shock. And when promptly deliverable oil is cheaper than later-dated futures, they call it a contango.
Conversely, low inventory levels make immediate access to oil very valuable. When that happens, it normally allows for more expensive spot prices.
The recession has prevented any such situation for a while now. As unemployment and general panic rose, oil prices moved into contango. Unused shipments strained tank capacity everywhere, including Cushing, Oklahoma, the delivery point for U.S. crude oil futures.
Those bulging inventories led to a severe discounting at the front end of the business. At its worst, spot prices were a whole $21 less than futures. And that prompted sellers to stockpile the commodity, hoping to profit more at a later date.
Of course, if the situation reverses, speculators will sell those extra supplies just as fast as they can take advantage of the higher prices. It could also increase the number of institutional investors who invest in commodity index funds.
Notably, oil represents as much as 40% in some of the underlying indexes.
Investors face stiff headwinds in a contango market. The index funds sell expiring futures, which sell for less than the next futures, which they then have to buy as they rollover their investment… If that all sounds like a mess, it’s only because it is.
Investors much prefer backwardation markets. That way, they pocket money as the index funds rollover, since further-out futures are cheaper than the futures they original sold.
Last year alone saw a record $68 billion put into such commodity investments. And if backwardation does occur, that number could rise even further.
Oil Demand Finally Catching Up With Supply
Backwardation would also signal that oil demand is finally playing catch-up with supply after a severe, recession-induced lag.
There are glimmers of that change already, at least on the global stage. Though demand is still weak in Western economies, it’s growing rapidly in China, India and other emerging economies.
According to oil consultancy Platts, China’s oil demand in December jumped 16.1% from the year before. And demand rose to 8.16 million barrels of oil per day. In fact, the country’s crude oil imports hit an all-time high of about 5 million barrels per day that month.
That won’t change anytime soon either. Chinese oil imports should remain high for at least the next few months thanks to higher crude runs at refineries and expanding stockpiling facilities.
Overall, the International Energy Agency believes that global oil use will grow by 1.8% to 86.5 million barrels a day this year, after a previous two years of decline.
Amrita Sen of Barclays Capital summed the situation up nicely: “What you’ve got is a global balance that is tightening, and probably more quickly than a lot of people are expecting.”
Three Ways to Play Backwardation
As usual, there are a number of ETFs available to take advantage of the situation. In this case, they hold oil futures contracts, which allow individuals to easily invest into oil futures.
Some of the particularly promising ones include Powershares DB Oil Fund (NYSE: DBO) and the United States Oil Fund (NYSE: USO).
The same firm that offers USO has another interesting offering in the United States 12 Month Oil Fund (NYSE: USL). Consisting of the 12 nearest month futures contracts on crude oil, it offers a good play if backwardation does not occur.
One way or the other, investors should watch to see if backwardation occurs and what happens then. If it comes and stays for a month or more, that signals higher oil prices in the short-term. And it could even indicate a return to the races of 2008.
Good investing,
Tony Daltorio
- The Crude Oil Contango: How to Profit From Rising Oil Prices
- How To Play the Oil Conspiracy Theories
- Oil Prices Retreat as Key Players Abandon the Market
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