One of the great luxuries of being out of the oil trading segment of the energy business is the ability to go days without looking at a screen to check on the price of oil. There are even times when I only hear about it on the evening news, something that would have been unthinkable when I needed to know what it was practically every minute. This is a long way of saying that I had missed the oil market's recent shifted from "backwardation" into "contango" until a friend emailed me an analyst comment to that effect. What does this change mean, and what does it say about the future trajectory for oil prices?
First, a quick explanation of the terminology. In backwardation, the price of the nearest or "prompt" commodity month on the exchange is higher than that of the next month, and so on. Contango is simply the reverse of this. Generally speaking, backwardation is a sign of strong demand or weak supply (or both), while contango indicates a market that is becoming oversupplied. The current market, which not long ago was fully "backwardated", is actually a bit of both today: contango through this September (with a really big May/June delta), and then mild backwardation as far as the eye can see.
What I find so interesting is not just this unusual hump-backed shape, but the fact that the contracts for five years out, which only a year ago were still in the high $20's and six months ago barely broke $40, are still in the high $40s. In fact, you have to get well into 2007 to find anything below $50. Think about that. Somebody (however many folks are buying oil for delivery in 2009 or 10) is betting that demand will outgrow or match the industry's ability to bring on new production for five years! I don't think there have been many five year periods in the last 100 years when that would have been true, barring the "oil crisis" years from 1973 to the early 1980s or WWII. Either there has been a structural shift in the market, or some speculators are going to get seriously burned.
In any case, the market is suggesting a bit of oversupply at the moment, with the expectation that demand will remain strong. Certainly US crude oil inventories are continuing to grow, sitting right at the top of their seasonal-normal range, and gasoline stocks seem to have stabilized. All of this bodes for weaker crude oil prices ahead, and possibly even wider contango, but that may not translate into much relief at the gas pump this summer, because extra crude doesn't translate into extra products if refineries are running close to flat out.
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