Oil Futures Point To Higher Oil Prices

The EIA reported another strong week of inventory declines in its most recent data release, revealing a drawdown of 6.5 million barrels for the week ending on August 4. That means that the U.S. has now pulled more than 60 million barrels from storage since inventories peaked in March at 535 million barrels.

More importantly, there is growing evidence to suggest that the inventory drawdowns will continue and might even accelerate. That evidence can be found in the futures market, where changes in longer-dated contracts are no longer trading at a much higher price than near-term prices.

For much of the past three years, the oil futures market has been stuck in a state of contango - a situation in which oil contracts for the next month are trading at a steep discount compared to oil futures that would expire in six or twelve months. It may seem like some esoteric financial nonsense, but the contango was a glaring symptom of a market that was suffering from a glut of supply.

In essence, the front-month oil price was so discounted because there was too much oil moving around the globe. It was not a coincidence that the contango was the most pronounced when spot oil prices dropped to their lowest levels, such as in early 2016 when WTI dipped below $30 per barrel.

Now, things are changing. The contango has narrowed significantly, to the point of virtually disappearing. Which is to say, oil contracts for near-term delivery are priced just about the same as contracts six months ahead.

Not only is that a sign that the market is tightening - as traders are no longer drowning in oil in the short run - but it also suggests that going forward, things will continue to tighten. That is because the contango provided an incentive to store oil. A trader could purchase crude, pay for storage, and sell at a later date at a higher price. But with the contango nearly gone, the cost of storage would make the trade uneconomical. Related: Oil Glut Endures As OPEC Confirms Higher Output

That means that the narrowing of the contango could induce sharper and more consistent declines in inventories, as traders unload cargo that they no longer want to store.

For oil prices, this is bullish, since the supply glut sitting in storage will continue to come down.

Moreover, if the futures market actually flips into a state of backwardation - in which near-term prices trade at a premium to contracts six months out - it would provide an even stronger bullish jolt to prices.

Backwardation would not only lead to stronger inventory declines, but it would also throw a wrench in the plans of U.S. shale, by taking away one of their most coveted strategies in today's market: hedging. Shale drillers typically lock in a certain portion of their production a year ahead of time, which insulates them from another downturn. Because the futures market has been in a state of contango, drillers were locking in much higher prices for the next year relative to today's price. So they could be profitable even as the prevailing spot price looked weak.

Backwardation would upend that calculation. If all shale drillers have to go by is a futures price that is actually lower than today's price, then the incentive to hedge is much diminished. That could translate into spending cuts, more modest drilling programs, and ultimately, lower oil production in 2018. Without the certainty of locking in production with hedging, it would be much riskier for these drillers to move ahead aggressively. To sum up, a shift into backwardation could slow the growth of shale to some extent. Related: A Red Flag For Oil? China's Crude Imports Drop To 7-Month Low

In this sense, OPEC's cuts have started to bear fruit. By taking barrels off of the market, they are draining inventories and narrowing the market contango. The end goal is higher prices, and we will eventually get there.

The one other wrinkle in this argument is the unpredictability and changing nature the futures curve. Shale can start and stop supply so quickly, that the longer-dated futures are much less reliable than they used to be. "Supply was always considered fix…but the reality is supply now can move faster than demand," Goldman Sachs' head of commodities research, Jeff Currie, told Bloomberg. "Velocity of supply changes the way these markets trade. When you look at oil…commodities are not anticipatory assets. They can't price the future, they gotta price today." Currie argued that the OPEC cuts last November changed the futures curve for the next year, but as the market priced in the expected change, it led to a supply response almost immediately from U.S. shale. In other words, "you can't be trading oil three to six months out, because the supply can respond…you can't be trading long-dated oil anymore," Currie said.

Nevertheless, going forward, the futures market is starting to point to market tightness, a sign of stronger inventory declines and eventually higher prices.

By Nick Cunningham of Oilprice.com

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