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Nick Cunningham

Nick Cunningham

Nick Cunningham is a Vermont-based writer on energy and environmental issues. You can follow him on twitter.

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Shrinking Contango Points To OPEC Deal Success

OPEC

The OPEC deal has sparked a rally in prices over the past few weeks, and crucially, it has also started to alter the shape of the futures curve, which could help accelerate the move towards balance in 2017.

The oil futures curve has started to flatten, which is to say that instead of near-term contracts trading at a steep discount to futures further out – a structure known as a market “contango” – oil for immediately delivery is starting to move closer to parity with contracts six months or a year out. The shrinking contango will be a central determinant in how quickly the oil market moves closer to a balance in supply and demand.

Indeed, this could be a key objective for OPEC – flattening out the futures curve in order to induce a faster drawdown in the enormous volume of oil sitting in storage. Here is how it might play out.

When the market is in a state of contango, oil traders have an incentive to sit on that oil and sell it at a later date since they can fetch a higher price. As long as the futures curve is steep enough – which reflects a sharper discount for oil in the near future – traders can cover the cost of storage. They sell the oil for delivery in six months, or a year, or two years from now and make a tidy profit.

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But the curve reflects real world physical conditions of supply and demand, and thus, it can change. If OPEC makes steep cuts to its production output, it can alter the global supply balance virtually overnight. The cartel has pledged to cut 1.2 million barrels per day (mb/d) in the first half of 2017, and has leveraged its cooperation to secure almost another 600,000 bpd from non-OPEC countries. The combined 1.8 mb/d vastly exceeds the current surplus of less than 1 mb/d. If OPEC follows through on the cuts, then the supply balance will tip into a deficit in the first half of 2017, forcing inventories to come down.

That has a knock on effect in the futures market that is also useful for OPEC. If the near-term (i.e. 1H2017) supply conditions grow tighter, then the market contango starts to narrow. In recent weeks, the market has even flipped into backwardation, a structure in which near-term contracts trade at a premium to further out. An oil contract for delivery in September 2017 now trades higher than a future for oil in December 2018. This reflects market sentiment about tighter supply conditions in the short run.

A contango that narrows and ultimately flips into backwardation makes storing oil a money-losing proposition since one would have to pay for storage costs and then ultimately sell oil at a lower price later on. If backwardation holds, inventories could start to get unloaded much quicker than they otherwise would have, which of course, will lead to higher oil prices.

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Moreover, as Bloomberg notes, backwardation also creates a predicament for oil drillers looking to hedge their production. If the futures market is discounting contracts out into the future, then there is less of an advantage of locking in future production, since they would be doing so at lower prices. As a result, shale drillers will operate with a bit of uncertainty, leaving future production unhedged, which could force high-cost producers to wait to drill new wells – an advantage for OPEC.

This is all to say that OPEC has a large incentive to actually comply with the terms that it laid out as part of its November 30 agreement. The group has a long track record of non-compliance, and even former Saudi oil minister Ali al-Naimi admitted that the group “tends to cheat.” And while the markets remain skeptical that real cuts will be forthcoming, OPEC members might actually want to comply as much as possible to achieve the market impact detailed above. In fact, Goldman Sachs has revised up its estimate for OPEC compliance, predicting that the group will achieve an 84 percent compliance rate with the November deal.

There is no guarantee that this scenario plays out, but if it does, then OPEC might actually achieve its goal of accelerating the oil market to a state of balance.

By Nick Cunningham of Oilprice.com

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  • Mrinal on January 05 2017 said:
    Fantastic analysis! This is the first time I read about somebody doing an analysis on the real objectives of OPEC.

    Another factor for OPEC compliance would be the financial conditions of the members. They have burnt though their cash reserves and are now releasing the importance of cooperation in achieving higher oil price.

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