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A Real Opportunity For An Oil Price Recovery

Eagle Ford rigs

The OPEC production agreement, which we called correctly, has already helped hoist the profitable oil stocks we held, but what about 2017? One way I’ve looked at oil and oil stocks is by looking at the crude curve – the differentials between monthly contract prices. And a recent big move in the curve makes 2017 look very positive indeed.

I’ve seen all kinds of futures curves in my 30+ years of trading oil, and many analysts believe that the crude curve is really predictive of the future –but more often than not, it is merely an outline of what traders and hedgers are thinking.

here’s a look at Thursday's curve:

 

These numbers represent an enormous change from the numbers we saw even two weeks ago, before the big OPEC deal in Vienna. Since 2014, we had been seeing a deep contango market, where oil prices in the future were a lot higher than where they were trading in the front (present) months. But what does a contango market mean?

Many like to look at contango markets as a signal of crude storage, and that has merit – but I like to look at the curve through the eyes of its participants: when the oil market is collapsing, as it has been since 2014, players in the futures markets know that the costs of oil recovery fall well above the trading price, and will buy future oil contracts banking on a recovery. This drives buying interest away from the present and into the future and creates our contango. This kind of market is dominated by the speculators, who are willing to buy (bet) on higher prices later on.

In contrast, the hedging players are in retreat in busting markets, dropping capex and working wells and trying merely to survive to see the next boom. It’s when prices begin to recover and they gain confidence in future prices that they try to hedge and plan for the coming up-cycle. This is when speculators, if they are buying, are likely to move closer to the front months if they’re buying while producers (commercials) are looking to sell futures 12-24 months out. Suddenly, you have a curve that is being more dominated by commercial players, selling back months and creating the backwardation we’re starting to see right now. Related: Oil Markets Not Convinced OPEC Deal Can Kill The Glut

You may remember that I was able to nearly predict this year’s bottom in oil prices by looking for that flattening move of the crude curve in February. This latest move from a discount to a premium curve has moved more than two dollars in the last week alone. This gives me added confidence in oil prices for 2017:

 

Let’s look, as a practical matter, why a premium (backwardated) market is absolutely REQUIRED to see a long-term recovery in oil.

Imagine you’re a shale producer and you’ve seen prices move from $45 to $52. You’ve been waiting for a move like this to restart some non-core acreage that you could have working by the middle of 2017. With a deep contango market, you might have gotten $55 or even more for a hedged barrel of crude in June of 2017.

But you’re not alone in looking to come out of your bunker, hedge some forward production and restart some idle wells – every other producer is trying to do the same thing. If all of you could depend on a future premium, every producer would hedge out new production and ultimately add to the gluts that have been already slow to disappear. Related: The OPEC Effect? U.S. Rig Count Spikes Most In 31 Months

If you think about it, a premium market works to DISCOURAGE fast restarts and quick restoration of gluts that a two-year rebalancing process has only slowly managed to fix – and this is a good thing. Producers have to be wary of adding wells so quickly, even in a market that is clearly ready to again rise in price. In a truly backwardated market, the futures work to keep the rebalancing process on track and production increases slow. That governor on production is the key to keeping a rallying market strong, and the frantic addition of wells at a minimum.

The proof of all this is in the type of curves we see depending on how the markets are trading.

Now, take another look at the December-December spread chart I put up and you’ll see that a Contango market was a critical component to the bull markets we saw in oil prior to 2014. Unless something very strange is happening, a Contango curve is indicative of a strong market, while a backwardated one indicates a market under pressure. It’s something I’ve watched closely for more than 30 years to help me find major trends.

And convinces me today that oil will have a constructive 2017.

By Dan Dicker for Oilprice.com

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